What is the risk-free rate? Why does it matter? What’s its purpose? How do you use it? We’ll explore all of this and more in this article. Let’s get into it.
As an investor, you would probably like your money to grow at a guaranteed rate of 10% per year without fail. Without even the possibility of losing money!
Unfortunately, this just isn’t the case. It’s not how the world works!
Every investment where there is potential for reward comes with some risk that you might lose your money.
There are some investments that are riskier than others, and they generally come with higher rewards if they are successful.
However, there is a theoretical number known as the risk-free rate of return that serves many purposes for investors.
Don’t get ahead of yourselves, though – it’s quite a bit more complicated than simply a rate of return with no risk!
It does however, relate to the closest thing that comes to the theoretical concept of risk-free assets.
Let’s get into the details and explain what it is and how it can be used.
What Is the Risk-Free Rate?
The risk-free rate, or the risk-free rate of return, is the theoretical rate of return for an investment that involves zero risk.
It’s important to remember that this is a theoretical number, but it still carries some importance in judging how well a particular investment performs.
From a practical standpoint, the risk-free rate is often synonyms with the yield of Government Bonds, typically those of Treasury Bonds.
Let’s make sure we’re clear on what these actually are.
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Treasury Bonds – A Brief Overview
Getting a quick overview of treasury bonds is useful as this information will come in handy later.
There are three main types of debt issued by treasuries of developed nations in terms of their maturities: long-dated maturity, medium-dated maturity, and short-dated maturity.
- Long-Dated Maturity bonds typically refer to 30-year maturities and are the longest-dated bonds.
- Medium-Dated Maturity bonds usually mature between two years and ten years. The yield is generally lower because the term of the note is shorter and there is lower risk.
- Short-Dated Maturity bonds typically mature in between four weeks and two years and tend to pay the lowest interest.
U.S. Treasury bonds, notes, and bills are generally seen as the lowest-risk investment one can make.
This is mainly due to the very low likelihood that the governments of developed nations, such as the US, UK, Canada, Germany, etc., will default on their debts.
Put differently, these bonds have very low default risk.
Yes, it’s still theoretically possible for governments to default on their debt – including developed nations. But the likelihood of this happening is very low.
Okay, now that you know what the risk-free rate is, let’s think about how we calculate it.
How Is the Risk-Free Rate Calculated?
The risk-free rate isn’t exactly a published number like inflation or the consumer price index (CPI).
It is a calculation that often starts with deciding a term over which you intend to invest.
This varies depending on whether you’re an individual investor or a business, but we’ll get more into that later.
Next, the lowest-risk investment you can make is generally a treasury bond in the currency you wish to invest.
You wouldn’t want to compare the US risk-free rate with an investment you intend to make in the UK, for instance.
By the way, you can check out recent data on the risk-free interest rate on Bloomberg here.
The risk-free rate is usually based on what’s known as a proxy (typically, the yield to maturity of U.S. treasury bonds).
Once you figure out the two points above about the term length and the currency, the proxy would generally be the yield on the government bond that matches those criteria.
In other words, the rate of return of that government bond is your risk-free rate.
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In most market conditions, the 3-month government bond rate of return is the often go-to proxy for a risk-free rate.
That’s mainly because it tends to represents the lowest risk.
After all, the likelihood of a developed country collapsing within three months is very, very low.
Note that this isn’t something that’s set in stone, however.
One could make equally compelling arguments about using the yields of long-dated maturity bonds as the risk-free rate.
Now, for a bit more information, there is something more specific called the “real” risk-free rate of return.
Whenever a rate of return includes “real,” it usually means that inflation is being deducted for a realistic estimate of the value over a long period of time.
If you’re wondering how to calculate the yield to maturity itself, no need to wonder.
This is something we cover quite extensively in our bond valuation course so do check that out if you want to learn more.
What Is the Purpose of the Risk-Free Rate?
The risk-free rate has several uses.
Because it is a theoretical number, it is used in lots of financial calculations used by economists and larger companies.
Regular investors can use it, too. Let’s start with how you can use the risk-free rate. We’ll then give you an idea about how economists, governments, and businesses can use it.
How Should Regular Investors Use the Risk-Free Rate?
Regular investors should at least understand what the risk-free rate is in order to compare investments.
An investor might have £10,000 in an investment portfolio but they have cash or cash equivalents of £1 million.
This is an unlikely scenario, but it illustrates the point. In that case, a smart financial advisor would bring up the risk-free rate.
Even though their small investment portfolio might be returning 10%, their cash is losing value equivalent to the inflation rate every year. This is because of the time value of money.
If they invested in a comparable risk-free investment, they would be much better off. Or at the very least, not worse off.
Regular investors can also look at the risk-free rate a bit closer to better understand current economic conditions.
By comparing two bonds with different term lengths, you can get an idea of where the market seems to think things are going.
As an example, in the US, the 10-year T-Note and the 3-month T-Bill are compared to gauge the likelihood of a recession or financial crisis within 12 months.
It’s not an exact science per se.
But it’s a tactic that can help investors in any country decide whether it’s the right time to buy an asset.
How Should Businesses and Governments Use the Risk-Free Rate?
Without diving too far into the complex maths, governments and financial institutions use the risk-free rate to determine how to price the interest they charge on money that gets lent out.
It is a critical component in several financial calculations such as risk premium, expected return of an investment (e.g., estimated using the CAPM), and the Sharpe Ratio to name a few.
These are used to gauge how much an investor should pay based on:
- the risk of the investment
- the expected monetary return on investment, and
- how well an investment is performing, respectively.
While businesses are perhaps more interested in making sure they continue to churn out profits, a good CFO will fully understand the risk-free rate and make sure the company’s funds are allocated in such a way that they will continue to be available.
Is the Risk-Free Rate Actually Free of Risk?
Unfortunately, there is no such thing as an investment that actually carries zero risk.
While it is unlikely that HM Government or the US Treasury will crumble within the next 3 months, no one can tell you what the world will look like in 10 years.
Obviously, most nations would like to continue growing and prospering, so you probably have nothing to worry about.
However, the fact that the risk of a global market crash exists means that you should approach the “risk-free” rate from a purely hypothetical standpoint.
As we mentioned, the risk on the chosen proxy is that the government that issued that bond could default on its payments.
Let’s preface this by clarifying that a risk-free rate only really exists in a developed country, so buying the 10-year bond issued by the government of a developing country with weak bond ratings is a different discussion entirely.
Final Thoughts: What Is the Risk-Free Rate?
While no investment is completely free of risk, the risk-free rate has a number of applications that can prove helpful to even average investors.
Whether you want to understand:
- how your whole portfolio is performing
- what the market is saying about economic conditions
- what the expected return on a security is…
Average investors can benefit from understanding which assets to look at to use the risk-free rate.
Calculating the risk-free rate can be simple or complicated.
Mostly, you can simply search “what is the current risk-free rate,” and your favorite search engine should pop out the figure in your home country.
It’s always good to double check the numbers, though. Because, as we show time and time again in our finance and investing courses, even the most sophisticated spreadsheets, websites, and data sources can get things wrong.
Be sure to learn how to calculate the yield to maturity, and how to value bonds by checking out the course below.
Keep learning, keep growing!
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