The Risk-Free Rate

The risk-free rate is the rate of return offered by an investment that carries zero risk.

Every investment asset carries some level of risk, however small, so the risk-free rate is something of a theoretical concept. In practice, it’s considered to be the interest rate paid on short-term government debt.

What Is the Risk-Free Rate?

All investing involves balancing risk against expected returns. All other things being equal, when you take on more risk, you can earn a greater return on your investment. Take on less risk and you’ll earn a lower return.

And when you take on zero risk, you earn the risk-free rate.

What sort of investment offers zero risk? Typically, U.S. government bonds are considered to be risk-free investments, because the federal government has never defaulted on its debt.

U.S. Treasurys are secured by the federal government, and the probability of a U.S. government default is practically zero. That’s why they are universally considered to be the safest asset that investors can own.

The Risk-Free Rate and U.S. Treasurys

U.S. Treasury bills, commonly referred to as T-bills, offer the shortest maturity debt securities issued by the federal government. They are the closest investors can get to a zero-risk investment, for two reasons.

First, as noted above, there is a nearly universal belief that the U.S. government will always make good on its debt. Unlike corporate bonds or municipal bonds, T-bills are backed by the full faith and credit of the U.S. government, which has never defaulted.

Secondly, the market for U.S. government debt is the largest and most liquid market anywhere on earth. As of April 2022, SIMFA reports that the market cap for U.S. Treasury-issued securities was $23.3 trillion, with $679 billion being actively traded.

That’s a hefty market, considering it’s almost two-thirds the market capitalization of the S&P 500, which was $38.29 trillion in March 2022. Thanks to the enormous size and trading volume of the treasuries market, investors know there will always be buyers for their T-bills when they need cash.

The yield on a three-month T-bill is regularly quoted as the day’s risk-free rate for U.S investors.

Nominal Risk-Free Rate vs. Real Risk-Free Rate

There are two ways to talk about the risk-free rate: the nominal risk-free rate and the real risk-free rate. The difference is due to the impact of inflation.

The nominal risk-free rate is typically the current yield of the 3-month T-bill without taking into account the impact of inflation. The real risk-free rate is the yield of the 3-month T-bill minus the impact of inflation.

The real risk-free rate is the yield an investor would need on a prospective investment not to experience inflation risk, providing inflation rates stay the same or decrease.

How Does the Risk-Free Rate Work?

The risk-free rate is the starting point for building different valuation models. These models use the risk-free rate to help understand how taking on more risk can impact your investment returns.

The return on a risk-free asset is used as a baseline to calculate risk premiums, for instance.

A risk premium is the higher rate of return investors demand from riskier assets like stocks. When you own stocks, you have taken on a greater risk of losing money in exchange for the potential to earn higher returns. Calculating a risk premium starts with the risk free rate.

It’s also the starting point for the capital asset pricing model (CAPM), which measures systemic risk and its impact on the value of an asset. The CAPM helps investors estimate the fair value of an asset and understand the relationship between risk and expected returns.

The risk-free rate is also important for calculating the Sharpe ratio. This analytical tool is used to evaluate the risk-adjusted returns on a single security or an entire investment portfolio. For both CAPM and the Sharpe ratio, the higher the ratio, the better the investment.

In each of these valuation models, U.S. Treasury securities with longer or shorter durations stand in for the risk-free rate. Typically, a treasury maturity is chosen that matches the investing time horizon of the asset that’s being analyzed.

How To Calculate The Risk-Free Rate

The formula for the risk-free rate is simple: It’s just the current yield of the three-month T-bill. However, the formula to calculate the real risk-free rate has a few more steps.

First, here’s the formula:

Real Risk-Free Rate = Risk-Free Rate – Inflation Premium

Say you’d like to invest in a 12-month certificate of deposit (CD) that yields 2.50%. If the current risk-free rate is 2.04%—the yield of a 12-month T-bill—you’re coming out almost half a percentage point ahead of the T-bill with the CD. Great work! Or is it?

Let’s suppose the inflation rate is the same as it was in May 2022: 8.3%. Now, do the math again.

Real Risk-Free Rate = 2.04% – 8.3%

So the real risk-free rate is -6.26%. By investing in the CD, you’d be falling 6.26% short of keeping pace with current inflation rates.

If your goal is to grow your money and retain purchasing power, you’ll probably want to look for a different investment with higher yields. In an inflationary economy, that typically means a riskier investment.

How Zero Interest Rates Impact the Risk-Free Rate

When the economy slows and threatens to dip into recession, the central bank may opt to lower interest rates and boost the amount of money flowing into the economy.

The U.S. saw this happen during the Covid-19 pandemic, when the Federal Reserve cut the federal funds target rate to zero and kept it there for almost two years.

That monetary policy choice reduced T-bill yields to historically low levels. While the U.S. Treasury can’t sell T-bills with negative yields, they can come up for sale on the secondary market at negative real yields, and investors may flock to them under the right circumstances.

When there are few places to find safe yields, T-bills are often sold at a premium. Some investors want to keep their money in a security that’s considered safe. While they may not make money, or even lose purchasing power after the impact of inflation, they may lose less than if they invested in higher-risk securities.

In low-inflation economies, zero or near-zero interest rates translate to real risk-free rates that are low. For example, if the inflation rate was a nominal 2.5% and you were considering that same 12-month CD at 2.5% above, your real risk-free rate would be zero, making it a break-even investment.

While these sorts of CD yields are an unlikely scenario in a near-zero interest rate economy, you can see what kind of yield it would take on a 12-month T-bill to earn nothing.

The Bottom Line

While the risk-free rate is ultimately a theoretical concept, the ability to calculate and understand the real risk-free rate is helpful for several reasons.

First, you can evaluate whether an investment will help preserve your purchasing power in an inflationary economy. Next, you can evaluate investments of different durations to see if a particular duration will offer you returns that help keep pace with or outpace inflation for the investment term.

It’s never a bad idea to run the numbers to see if a particular low-risk investment makes sense in the current economy. You now have a tool to do just that, and it only takes moments to figure out your risk-free rate of return.

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