What is the Risk-Free Rate of Return?

Investing is the holy grail of financial freedom. You save enough from your primary source of income to invest in an instrument that can provide adequate returns to multiply the invested amount over time. The compounding effect creates a chain reaction that can provide you with enough capital over time. However, investing is not easy as the market and the rate of return for almost every investment instrument are highly affected by external factors.

These factors, such as economic growth, GDP, geographical events, negative/positive news etc., can force the rate of return to fluctuate and result in decreasing returns. For an investor, the goal is to invest in a risk-free instrument, which is explained through the risk-free rate of return.

What is the risk-free rate of return?

The risk-free rate of return is a theoretical number within the capital markets that pertains to an investment that provides guaranteed returns with negligible or zero risk. In the financial market, a risk-free rate of return is attributed to the interest payments or the rate of return received by an investor on the money invested in a risk-free financial instrument over a specific period.

Although investors have searched for years to find an instrument that has a risk-free rate of return, the theoretical principle is yet to be proven. For now, a risk-free rate of return does not exist, as there are no investment instruments that carry zero risk. However, Treasury Bills are the only instruments that are considered close to earning a risk-free rate of return. It is because the government backs them and the probability of the government defaulting on interest payments is almost negligible.

Understanding Risk-Free Rate of Return

The basic goal before choosing an investment is to earn a good rate of return with a negligible risk factor. However, there may be some investments that come with lesser risk than others; it is not possible for a financial instrument that trades in the free market to come with zero risk.

The risk-free rate of return reflects three core components theoretically:

• Inflation: Inflation means a considerable and persistent rise in the general level of prices of goods and services in an economy over time. Here, it is the inflation rate throughout holding the risk free investment.
• Rental Rate: Rental rate is the actual realised rate of return on the investment. Here, it is the rate of return of the risk-free investment that the investor gets regularly without default.
• Investment Risk: It is the risk that comes with every investment tool and can force a decline in the value. Here, the investment risk is reflected as zero, where the investor cannot make losses.

Calculation of Risk-Free Return

Generally, a basic principle to calculate the risk-free rate of return is to use the investment time in the risk-free instrument. However, one of the most respected financial models to calculate risk-free returns is the Capital Asset Pricing Model (CAPM). It calculates the risk-free rate of return by equating the returns on the security to the sum of the risk premium and risk-free return. The Capital Asset Pricing Model formula is as follows:

Ra = Rf + [Ba x (Rm -Rf)]

where Ra = return on a security

Ba = beta of a security

Rf = risk-free rate

• The risk premium is calculated as the difference between market return and risk-free return as stated in the formula as Rm - Rf.
• The beta of a security is the measure of the volatility or systematic risk attached to a security or an investment tool. In the CAPM model, the beta explains the relationship between expected returns for assets and the associated systematic risk.

Example of Risk-Free Return

Risk-free returns are almost impossible to find as there is risk attached to every single financial instrument. However, for an investor wanting to replicate the theoretical number of a risk-free rate of return, the closest example is Treasury Bills. Treasury bills are issued by the government and mature within one year. These bills do not offer a fixed interest payment but offer returns at maturity by allowing investors to buy the bills at a lesser rate than the face value.

Since they are issued by the government they carry almost negligible risk, there are very less chances of the government having no money to provide interest to the investors. For example, you can buy a treasury bill with Rs 100 face value at Rs 98 and get a return based on the difference between the face value and the issue price.

Final Word

A risk-free rate of return is a theoretical number that explains the rate at which an investor is provided interest payments on the money invested in a risk-free investment tool. The theory imagines an ideal process to realise guaranteed returns with zero risk. However, as there is no financial instrument with zero risk, an investor needs to evaluate various instruments on their risk profile before investing. Identifying the investment horizon is one of the most important aspects of finding the closest investment instruments to earn a risk-free rate of return.