Risk-Free Rate: Importance & Applications Of This Financial Term
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The risk-free rate is one of the most fundamental components of modern-day finance. As the name suggests, it refers to the rate of return on an investment which theoretically carries zero risks.
In other words, a risk-free rate is a minimum return that you can expect from an investment. That’s because investors don’t accept further risks unless they get higher return rates than the specified risk-free rate.
The risk-free rate has a theoretical existence. It is only used for calculation purposes. In actuality, all investment options are subject to risk and volatility. However, if you consult an expert advisors in Wealthface, you can minimize risks and maximize returns. Wealthface helps in creating a customized investment portfolio such that the risks are adjusted according to your risk tolerance. Let us find out more about risk-free rate and its implications.
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Everything you need to know about risk-free rate
As stated earlier, the risk-free rate is the bare minimum return value that investors will receive from an investment. Hence, it also acts as a benchmark for all other rates of interest.
Other financial institutions set their interest rates based on the risk-free rate.
How do you calculate the risk-free rate?
The risk-free rate determines the return an investor can expect over a specified period of time from an investment.
The value of a risk-free rate is calculated by subtracting the current inflation rate from the total yield of the treasury bond matching the investment duration.
For example, the Treasury Bond yields 2% for 10 years.
Then, the investor would need to consider 2% as the risk-free rate of return.
A formula is used to calculate the risk-free rate of return. The formula states as:
Risk-free Rate of Return = ( 1+Governmennt Bond Rate1+Inflation rate) – 1
Is the risk-free rate of return really free of risks?
It is true that while making investments, investors do expect a certain level and degree of risks associated with the investment.
After taking away all the risk, they do calculate a minimum ROI.
Learn: How to calculate Return on Investment?
In reality, the actual return that they receive might not always be equivalent to the amount they expected. This difference in the returns is because of the risks involved.
In today’s competitive world and volatile market situations, there is no such investment that offers zero risks.
Even the Treasury bills of the US are subject to market risks.
This doesn’t mean that the government has not defaulted on its obligations. However, such investments have the chance of carrying some form of risk, especially when a foreign investor is involved.
The theory of risk-free rate, therefore, doesn’t totally hold true in real life and its safety and security are rarely maintained.
An ideal risk-free rate doesn’t exist in practical situations.
Even the seemingly safest investments can carry certain amounts of risk, no matter how minimal they are.
Hence, for the US-based investors, the interest rates on a 3-month US Treasury bill is generally considered and used as the standard risk-free rate.
What is the importance of the risk-free rate?
A risk-free rate acts as a foundation for all other kinds of financial institutions, such as the cost of equity.
Therefore, to maintain a balance of the return of investment rates and to attract investors, other institutions must offer higher returns than the risk-free rate.
This means that other investments generally add a risk premium along with the risk-free rate.
Now, the size of the risk premium depends upon the extent of risk that a particular investment scheme carries.
For instance, a corporate-level bond such as one from a blue-chip company would certainly carry a much lesser risk premium compared to that from a small business or startup.
The risk-free rate is an essential determiner that enables investors to calculate other vital financial components such as the cost of equity.
It also helps to determine the weight average cost of capital (WACC) of the firm. WACC is referred to as the minimum rate of return that is required to create a suitable value for a particular firm.
This means that any project having a rate of return less than the WACC will have to suffer a reduction in the stock prices of the concerned firm.
Applications of the risk-free rate
The risk-free rate of interest has its applications in the capital asset pricing model that is based on the mean-variance analysis, better known as the modern portfolio theory (MPT).
Moreover, the risk-free rate of return is a primary input into the cost of certain capital calculations, including those that are performed with the help of the capital asset pricing model.
In that case, the cost of capital at risk is calculated by summing up the risk-free rate of return with a specific risk premium.
Besides, the risk-free rate also finds a significant application in various financial calculations, like the Black-Scholes formula that is required in pricing different stock options and setting the appropriate Sharpe ratio.
Also, some economic and finance theories assume that the market participants would be able to borrow their assets at risk-free rates.
However, in reality, some very rare borrowers have proper access to this level of financing, and they borrow at truly risk-free rates. This is not an option for retail clients.
The risk-free rate of returns doesn’t ideally exist in reality as even the most secured investments are subject to market risks and some amount of volatility.
The safest option is to read about all the terms and conditions thoroughly before investing.
To determine a proxy for the risk-free rate for a particular situation, you must analyze and consider your home market.
A wrong decision might lead to negative interest rates, thus further complicating the issue.
Hence, it is better to consult experts like Wealthface team for the best investment suggestions and support. Contact us now:
We analyze your risk profile and then we invest your money suitably based on your risk tolerance. So, you can choose us as your investment partner and head towards a more secured and better future.