Risk-Free Rate Of Return
The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.The so-called "real" risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.
Definition: The risk-free rate refers to the theoretical return on an investment with zero risk. It represents the interest that investors expect to earn from an absolutely risk-free investment over a specific period. Commonly, the risk-free rate is benchmarked by the yield on short-term government bonds, as these are considered to have negligible default risk.
Origin: The concept of the risk-free rate originates from the Capital Asset Pricing Model (CAPM), introduced by William Sharpe in the 1960s. In the CAPM model, the risk-free rate is a crucial component for calculating expected returns.
Categories and Characteristics: The risk-free rate can be divided into nominal risk-free rate and real risk-free rate. The nominal risk-free rate does not account for inflation, while the real risk-free rate is the nominal rate minus the inflation rate. The nominal risk-free rate is typically used for short-term investments, whereas the real risk-free rate is more suitable for long-term investment analysis.
Specific Cases: 1. Suppose an investor buys a one-year U.S. Treasury bond with an annual yield of 2%. If the current inflation rate is 1%, the real risk-free rate would be 2% - 1% = 1%. 2. When evaluating project investments, companies often use the risk-free rate as part of the discount rate to assess the Net Present Value (NPV) of a project. For example, if a company plans to invest in a new project with an expected annual return of 5%, and the current one-year Treasury yield is 1.5%, the company can use 1.5% as the risk-free rate to calculate the project's expected return.
Common Questions: 1. Is the risk-free rate truly risk-free? While termed as risk-free, there are still minimal risks, such as government default risk. 2. How to choose an appropriate risk-free rate? Typically, the yield on government bonds that match the investment horizon is chosen as the risk-free rate.
