What is a Risk-Free Rate and why is it important?
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What is Risk-Free Rate?
The risk-free rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the risk-free rate is commonly considered to be equal to the interest paid on a 10-year highly rated government Treasury note, generally the safest investment an investor can make.
The risk-free rate is a theoretical number since technically all investments carry some form of risk, as explained here. Nonetheless, it is common practice to refer to the T-note rate as the risk-free rate. While it is possible for a highly rated government to default on its securities, the probability of this happening is considered very low.
The security with the risk-free rate may differ from investor to investor. The general rule of thumb is to consider the most stable government body offering T-notes in a certain currency. For example, an investor investing in securities that trade in USD should use the U.S. T-note rate, whereas an investor investing in securities traded in Euros or Francs should use the equivalent Swiss or German note.
How Does the Risk-free Rate Affect the Cost of Capital?
The risk-free rate is used in the calculation of the cost of equity(as calculated using the CAPM), which influences a business’s weighted average cost of capital. The graphic below illustrates how changes in the risk-free rate can affect a business’ cost of equity:
Where:
CAPM (Re) – Cost of Equity
Rf – Risk-Free Rate
β –Beta
Rm– Market Risk Premium
A rise in Rf will pressure the market risk premium to increase. This is because as investors are able to get a higher risk-free return, riskier assets will need to perform better than before in order to meet investors’ new standards for required returns. In other words, investors will perceive other securities as relatively higher risk compared to the risk-free rate. Thus, they will demand a higher rate of return to compensate them for the higher risk.
Assuming the market risk premium rises by the same amount as the risk-free rate does, the second term in the CAPM equation will remain the same. However, the first term will increase, thus increasing CAPM. The chain reaction would occur in the opposite direction if risk-free rates were to decrease.
Here’s how the increase in Re would increase WACC:
Holding the business’ cost of debt, capital structure, and tax rate the same, we see that WACC would increase. The opposite is also true (i.e., a decreasing Re would cause WACC to decrease).
Further Considerations
From a business’s perspective, rising risk-free rates can be problematic. The company might have to adjust its internal investment policies to meet higher required rates of return demanded by investors.
Historical U.S 10-year T-note Rates
Below is a chart of historical U.S. 10-year T-note rates:
Source: St. Louis Fed
T-notes fell as low as 0.52% during the Covid pandemic and rose as high as 15.84% during the early 1980s. High T-notes rates usually signal prosperous economic times when private sector companies are performing well, meeting earnings targets, and increasing stock prices over time.
Additional Resources
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FAQs
The Risk Free Rate (rf) is the theoretical rate of return received on zero-risk assets, which serves as the minimum return required on riskier investments. The risk-free rate should reflect the yield to maturity (YTM) on default-free government bonds of equivalent maturity as the duration of the projected cash flows.
How to calculate the risk-free rate? ›
In practice, the risk-free rate of return does not truly exist, as every investment carries at least a small amount of risk. To calculate the real risk-free rate, subtract the inflation rate from the yield of the Treasury bond matching your investment duration.
What is the risk-free rating? ›
In practice, the risk-free rate is commonly considered to be equal to the interest paid on a 10-year highly rated government Treasury note, generally the safest investment an investor can make. The risk-free rate is a theoretical number since technically all investments carry some form of risk, as explained here.
What are risk-free rate terms? ›
A rate of interest used as a benchmark in financial transactions that is designed to exclude counterparty credit risk and account solely for economic factors. RFRs are considered more robust and less susceptible to manipulation than interbank offered rates (IBORs), such as LIBOR.
What is risk-free in CAPM? ›
The risk-free rate signals an investment that has no risk; the investor will not lose money. The rate is the main component of many famous theories, such as the capital asset pricing model (CAPM), modern portfolio theory (MPT), and the Black-Scholes model.
What is the risk-free rate for dummies? ›
It refers to the rate of return you could earn over a period of time on an investment that carries zero risk. So assuming an investment is completely risk-free, the risk-free rate of return would be what you would pocket by holding the investment.
How do you calculate risk rate? ›
A risk ratio (RR), also called relative risk, compares the risk of a health event (disease, injury, risk factor, or death) among one group with the risk among another group. It does so by dividing the risk (incidence proportion, attack rate) in group 1 by the risk (incidence proportion, attack rate) in group 2.
What is the ideal risk-free rate? ›
The Risk Free Rate (rf) is the theoretical rate of return received on zero-risk assets, which serves as the minimum return required on riskier investments. The risk-free rate should reflect the yield to maturity (YTM) on default-free government bonds of equivalent maturity as the duration of the projected cash flows.
Is risk-free rate the same as discount rate? ›
What is the appropriate discount rate to use for an investment or a business project? While investing in standard assets, like treasury bonds, the risk-free rate of return—generally considered the interest rate on the three-month Treasury bill—is often used as the discount rate.
What is considered risk-free? ›
A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them.
The main difference between the alternative Risk-Free Rates and LIBOR rates is that the new rates are overnight rates, and not term rates like LIBOR. There are fundamental and technical differences between LIBORs and the new RFRs.
Can you borrow at the risk-free rate? ›
Risk-free borrowing (investing on margin) means that an investor borrows money at a risk-free rate in order to invest in some other risky asset.
Can a risk-free rate be negative? ›
The correct interpretation is that the risk-free rate could be either positive or negative and in practice the sign of the expected risk-free rate is an institutional convention – this is analogous to the argument that Tobin makes on page 17 of his book Money, Credit and Capital.
How to count risk-free rate? ›
The risk-free rate can be determined by subtracting the current inflation rate from the yield of the Treasury bond matching the investor's proposed investment duration.
What is the difference between risk-free rate and beta? ›
Risk-Free Rate (rf) → The return received from risk-free investments — most often proxied by the 10-year treasury yield. Beta (β) →The measurement of the volatility (i.e. systematic risk) of a security compared to the broader market (S&P 500)
What is a good Sharpe ratio? ›
The Sharpe Ratio helps rank and indicate the expected return compared to risk: Usually, any Sharpe ratio greater than 1.0 is considered acceptable to good by investors. A ratio higher than 2.0 is rated as very good. A ratio of 3.0 or higher is considered excellent.
How is the risk-free interest rate determined? ›
In actual terms, the risk-free interest rate is assumed to be equal to the interest rate paid on a three-month government Treasury bill, which is considered to be one of the safest investments that it's possible to make.
How do you calculate risk formula? ›
Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact. In particular, IT risk is the business risk associated with the use, ownership, operation, involvement, influence and adoption of IT within an enterprise.
What is the formula for risk discount rate? ›
The RADR is calculated using the formula RADR = Risk-free Rate + (Beta x Market Risk Premium), where Risk-free Rate is expected return from a zero-risk investment, Beta is investment risk in relation to the market, and Market Risk Premium is the difference between expected market return and the risk-free rate.
What is the formula for expected rate of return risk-free? ›
Expected return = Risk Free Rate + [Beta x Market Return Premium] Expected return = 2.5% + [1.25 x 7.5%]
