Risk Free Rate

The Risk Free Rate represents theoretical return on zero-risk assets, setting the baseline for minimum returns expected on more volatile investments.
EXPLORE FUNDS
What is Risk Free Rate
EXPLORE FUNDS
3 min
19-September-2024
The risk-free rate of return is the theoretical rate of return of an investment with zero risk. It represents the interest one would expect from an absolutely risk-free investment over a specified period of time. This concept is crucial in financial theory as it serves as a benchmark for evaluating the performance of other investments. In India, the 10-year government bond yield is commonly used to represent the risk-free rate.

In this article, we will explore the concept of the risk-free rate, risk free rate meaning, also its significance and how it is calculated. We will examine the factors that influence the risk-free rate and discuss its role in various financial models and investment strategies.

What is risk-free rate?

Now that we have understood the risk-free rate definition; let us move on to the type of investment it represents. The risk-free rate represents the return on an investment with zero risk, typically derived from government bonds of stable countries. It serves as a benchmark for evaluating other investments and accounts for the time value of money. For instance, in India, the 10-year government bond yield is often used as a proxy for the risk-free rate. If this yield is 7.365%, it implies that an investor could expect a 7.365% return annually without assuming additional risk.

Also Read: What is a Discount Rate

Formula of risk-free rate (rf)

To dig a bit deeper into the risk-free rate, it's useful to know that there are two main types:

Real Risk-Free Rate

Nominal Risk-Free Rate

The difference between them comes down to whether inflation is factored in or not.

The real risk-free rate considers the return on investment after accounting for inflation, reflecting the true value of your money over time. On the other hand, the nominal risk-free rate is the straightforward return you get from risk-free investments without adjusting for inflation.

Here's how the real and nominal risk-free rates are related:

Real Risk-Free Rate (rf) = (1 + Nominal rf Rate) ÷ (1 + Inflation Rate) - 1


How to calculate risk-free rate (rf)?

In corporate valuations, many risk and return models start with the concept of a "risk-free rate." This is typically represented by the yield on a risk-free asset, like the 10-year government bond. This rate serves as the baseline return expected from investments considered to have "zero risk," and it's the foundation for many valuation models.

While this return is labeled as risk-free, it's worth noting that it's a simplified concept. No investment is completely risk-free. However, government bonds come close to being as risk-free as possible. Governments have the ability to print more money if needed, making the likelihood of default on these bonds very low. As a result, government bonds are often seen as the safest investment option available.

Also Read: How to Calculate Capital Gains Tax on MF

Real risk-free rate and inflation rate assumptions

When calculating the real risk-free rate, it's essential to consider both the nominal rate and the inflation rate. The nominal rate is the observed return on risk-free investments, while the inflation rate reflects the expected increase in prices over time. The assumption is that inflation erodes the purchasing power of returns, so adjusting the nominal rate helps investors understand the actual value of their investments. Accurate estimates of inflation and the nominal rate are crucial for meaningful risk-free rate calculations.

To understand the real risk-free rate, start with the nominal risk-free rate and adjust for inflation. For example, if the real risk-free rate is 5.0% and the inflation rate is 3.0%, you can calculate the nominal risk-free rate as follows:
Nominal rf Rate = (1 + 5.0%) × (1 + 3.0%) – 1, resulting in 8.2%.

To confirm this, you can reverse the calculation:
Real rf Rate = (1 + 8.2%) ÷ (1 + 3.0%) – 1, which brings us back to 5.0%. This shows how inflation affects the nominal rate to reflect the true return.

Nominal risk-free rate calculation example

To calculate the nominal risk-free rate, use the formula:
Nominal rf Rate = (1 + Real rf Rate) × (1 + Inflation Rate) – 1.


For example, with a real risk-free rate of 5.0% and an inflation rate of 3.0%, the calculation is:

Nominal rf Rate = (1 + 5.0%) × (1 + 3.0%) – 1, which results in 8.2%. This nominal rate represents the expected return on a risk-free investment before adjusting for inflation.

Also Read: What is the Cost Inflation Index

What is the role of the risk-free rate in CAPM?

In the Capital Asset Pricing Model (CAPM), the risk-free rate is a crucial component. It represents the minimum return expected from an investment with no risk, serving as a baseline. CAPM calculates the expected return on a risky asset by adding a risk premium to the risk-free rate. This premium is based on the asset’s beta (its risk compared to the market) and the equity risk premium (the difference between the market return and the risk-free rate). Essentially, the risk-free rate helps determine the additional return needed to compensate for investment risk.

How does the risk-free rate affect discount rate?

The risk-free rate directly influences the discount rate used in financial valuations. In the Weighted Average Cost of Capital (WACC) formula, the risk-free rate helps estimate the cost of equity, with an added risk premium reflecting the investment’s risk. If the risk-free rate rises, investors demand higher returns on riskier assets to compensate for increased rates. Conversely, lower risk-free rates lead to lower discount rates, which can boost the valuation of equities as the cost of capital decreases.

What is the impact of rising risk-free rate on valuation?

A rising risk-free rate can significantly impact valuations. For instance, during the COVID-19 market downturn, the 10-year government bond yield dropped to around 0.6% to 0.8%. Investors faced the choice between low-yield government bonds or higher-risk stocks. Many opted for equities, especially blue-chip tech stocks, anticipating better returns. As a result, stocks, particularly in the tech sector, saw substantial gains and contributed to the market’s rapid recovery. This demonstrates how changes in the risk-free rate can shift investor preferences and influence market valuations.

Also Read: Good Return on Investment

How risk-free is the risk-free rate of return?

Despite its name, the risk-free rate is not entirely free of risk. Government bonds, often used as a proxy, are considered very low risk because governments can print more money to meet obligations. However, they are not completely risk-free. Factors such as changes in inflation, economic conditions, and government creditworthiness can affect their returns. While these bonds are among the safest investments, they still carry some level of risk, making the term "risk-free" a bit of a misnomer.

Key Takeaways

  • The risk-free rate of return is a theoretical concept representing the return on an investment with no risk.
  • Investors typically won’t take on more risk unless they expect a return higher than this risk-free rate.
  • In reality, a truly risk-free investment doesn’t exist because every investment involves some degree of risk.
  • To find the real risk-free rate, subtract the inflation rate from the yield of a Treasury bond with a similar duration to your investment.

Conclusion

Understanding the risk-free rate is essential for evaluating investments and making informed financial decisions. While the risk-free rate serves as a crucial benchmark, it's important to remember that no investment is entirely free of risk. The risk-free rate helps investors gauge whether the potential returns justify taking on additional risk. By accurately calculating the real risk-free rate, investors can better compare different investment options and align them with their financial goals. For those seeking a wide range of investment opportunities, the Bajaj Finserv Platform offers access to over 1000 mutual funds schemes, providing a valuable resource for making well-informed investment choices.

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Frequently asked questions

What is the risk-free term rate?
The risk-free term rate is the interest rate on an investment that is considered free of any risk of default. It typically refers to the rate offered by government securities, such as government bonds, which are deemed virtually risk-free due to the issuing government’s ability to meet its obligations. This rate serves as a benchmark for comparing other investments that carry varying degrees of risk.

How to calculate the risk-free rate?
To calculate the risk-free rate, start with the nominal rate on a government security and adjust for inflation. The risk-free rate is typically derived from the yield on a government bond that matches the duration of your investment. For a precise calculation, you can use the following formula: Real Risk-Free Rate = (1 + Nominal Risk-Free Rate) ÷ (1 + Inflation Rate) – 1.

What is the risk-free rate in India now?
As of the latest data, the risk-free rate in India is often represented by the yield on government securities such as the 10-year government bond. For instance, the yield on the 10-year government bond as of October 2023 was approximately 7.365%.

What is risk-free in CAPM?
In the Capital Asset Pricing Model (CAPM), the risk-free rate represents the return expected from an investment with no risk of loss. It is used as a baseline to measure the return on risky assets. CAPM calculates the expected return on an asset by adding a risk premium to the risk-free rate. This model helps investors assess whether the additional risk associated with an investment is justified by the expected return compared to the risk-free rate.

What is meant by risk-free rate?
The risk-free rate is the theoretical return on an investment with no risk of financial loss. It is typically associated with government securities, like Treasury bonds, which are considered nearly risk-free because of the government’s backing. This rate serves as a benchmark for evaluating other investments by providing a base return that compensates for no risk. Understanding the risk-free rate helps investors gauge whether the extra return from riskier investments justifies the additional risk.

What to use as a risk-free rate?
When determining the risk-free rate, the yield on government securities, such as 10-year government bonds, is commonly used. These securities are backed by the government, making them the closest to a risk-free investment. The risk-free rate serves as a foundation for calculating market risk premiums and evaluating the returns on other investments. It’s crucial to use the yield of a government security that matches the investment duration for an accurate benchmark.

Is the risk-free rate the cash rate?
The risk-free rate is related but not identical to the cash rate. The cash rate is the interest rate set by a central bank, such as the Reserve Bank of Australia, for overnight loans between financial institutions. It influences broader interest rates in the economy, including those considered risk-free. However, the risk-free rate typically refers to the return on government securities, which are considered free from default risk and provide a baseline for evaluating other investments.

Can the risk-free rate be zero?
While theoretically possible in very low-inflation environments, a true zero risk-free rate is rare. In practice, even low-risk government securities usually offer a positive return, albeit small. For instance, during periods of extremely low inflation, the risk-free rate might approach zero, but it generally remains above this level to compensate for minimal risks associated with government-backed securities.

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