What is Risk Free Rate of Return?

Key Highlights

• Risk free rate is the ideal return on investment with no risk.
• Investors only take risks if the potential return is higher than the risk-free rate.
• In reality, no investment is entirely risk-free, they all have some level of risk.

Understanding What is Risk Free Rate of Return

The primary objective before selecting an investment is to achieve a favourable return while minimising the associated risks. Although some investments may have lower risks than others, it's impossible for a financial instrument to be entirely risk-free.

The risk free rate of return is theoretically influenced by three fundamental factors:

Inflation An economy's overall prices for goods and services rising noticeably and continuously over time is referred to as inflation. It stands for the inflation rate when investing in a risk-free environment.

Rental Rate The rental rate signifies the actual realised return on the investment. In this case, it relates to the regular return from the risk-free investment that investors receive without any defaults.

Investment Risk This factor symbolises the inherent risk associated with every investment tool, which can lead to a decrease in its value. In this scenario, the investment risk is considered to be zero, indicating that investors cannot incur losses.

Calculation of Risk Free Return

Traditionally, computing the risk-free rate involves considering the investment duration in a risk-free instrument. However, the widely respected Capital Asset Pricing Model (CAPM) offers a sophisticated approach to assess risk-free returns. According to CAPM, the risk free rate of return is derived by matching security returns with the sum of the risk premium and the risk-free return.

The CAPM formula is: Ra = Rf + [Ba x (Rm - Rf)] In this equation:

• Ra signifies the return on a specific security.
• Ba represents the security's beta, indicating its volatility or systematic risk.
• Rf denotes the risk-free rate.

The risk premium is determined by the difference between market return (Rm) and risk-free return (Rf) as outlined in the formula. Essentially, beta in the CAPM model elucidates the connection between expected asset returns and their corresponding systematic risk.

Example of Risk Free Return

An example of a risk-free return is challenging to find due to the inherent risks associated with most financial instruments. If investors want a safe way to make profit, they can consider Treasury Bills. These are like special papers sold by the government. They don't promise a fixed payment, but when you buy them for less than their worth, the government will pay you back the full amount when they mature, which is usually within a year. Given that the government backs it, investing in this way is safe, so there's a high chance you'll get decent returns on your investment. For example, if you buy a Treasury Bill worth Rs 100 for Rs 98, you'll earn profit based on the Rs 2 difference.

What does the risk free rate of returns signify for Investors?

Once you understand the basic idea of the risk-free rate of return, it's natural to wonder how it affects investors like you. This concern is totally understandable. So, let's talk about what the risk-free rate of return means for investors. It refers to investments that are considered completely safe, with no risk involved. Any other investment that has even a little risk must offer higher returns to attract investors. In simple words, the risk-free rate of return is the lowest expected rate of return from investments in the market.

This rate is like a standard for figuring out other rates, like the cost of equity. The cost of equity is calculated by adding extra money (called a risk premium) to the current risk free rate in the market. This accounts for the extra risk of different investment options. Similarly, the risk-free interest rate is used to figure out the cost of debt. The concept of risk-free rate influences how companies decide on their investment projects. When companies evaluate potential projects, they compare the expected returns from these projects with the risk-free rate.

Conclusion

A risk free rate is like a pretend number that shows how much profit you can make without taking any risks. It's an ideal concept, but in real life, there's no completely safe investment. So, before investing, people need to look at different options and see how risky they are. Figuring out how long you want to invest for is also really important when you're trying to find a safer investment.

The risk-free rate of return is a crucial factor to take into account as a benchmark for your investment selections, irrespective of the length of your investment period. It assists you in determining if the minimal rates of return on your investments are being earned. It's a sign that the additional risk you took paid off well if the actual rate of return exceeds the risk free rate of return.