Risk Free Rate of Return - Explained
What is the Risk Free Rate of Return?
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What is the Risk-Free Rate of Return?
The risk-free rate of return is the optimum rate of return on an investment with zero risk of default or loss. Restated, it is a hypothetical rate of interest that an investor would expect from an investment without incurring any risk. That means the investor is assured to get the principal amount and a minimal return over a specified period of time.
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How Does the Risk Free Rate of Return Work?
In reality, every investment carries a certain amount of risks, and a risk-free rate of return does not exist. Even the safest investments have a small number of risk factors attached to it. In the U.S., the interest rate on the three-month Treasury bill is considered to be risk-free. It provides the comparative basis for determining a risk-free rate of return. It is a theoretical number, as it is possible for even the governments to default on their securities (thought the chances are almost nil). The investors domestic market is an important factor that needs to be considered while determining a proxy for the risk-free rate of return. Negative interest rates further complicate the issue.
The U.S Treasury bill is an effective proxy for the U.S. Investors; but that might not be the case for investors whose assets are not denominated by dollars. For them, it incurs currency risk when investing in the U.S. Treasury bills. The perception of US Treasury safety depends on the large market size and its deep liquidity. For the non-U.S. investors, the rate of return might get affected even after hedging the currency risk via currency forwards and options. Short-term government bills of highly-rated countries allow risk-free investment to the investors based in less highly-rated countries with the same currency. Those short-term bills serve as the proxy for the risk-free rate of return for them.
As members of the European Union employing the Euro currency, investors based in Greece or Portugal can invest in highly rated German bonds without incurring currency risk; but, the investors with Russian rubles wont be able to avoid that risk while investing in the German bonds. The lowest allowed yield at a Treasury auction is zero. In certain situations, however, the bills might be traded with negative yields in the secondary market. In the U.S. debates regarding the need of raising the debt ceiling sometimes limit the issuance of treasury bills. The lack of supply reduces the prices drastically. The situation may lead to negative real interest rates (a situation where the bond returns less than the present value of cash considering inflation). Sometimes during persistent deflation, the governments are forced to follow a policy of very low-interest rates that may even become negative, in order to rejuvenate the economy. In such situations, investors tend to invest their money in the assets they consider to be the safest.