Investing is a tradeoff between risk and return. Safer assets give a lower rate of return because they have less chance of losing money. Assets that have no risk of losing money pay the lowest rate in the market, called the risk-free rate. This rate is found by looking at short-term debt from the richest and most stable countries in the world. Both individual and institutional investors use the risk-free rate in their analyses.
Risk & Return
An investment's annual return is what it pays back on your money after a year. Some investments, like bonds, pay out a fixed return every year while others, like stocks, give a different return every year. Risk is the chance that your return for the year is different than what you expected. This change could create a higher or lower return. Investors who don't like to gamble on their investments would rather receive a steady annual return versus one that keeps changing.
Risk-Free Rate Uses
Investors use the risk-free rate as a benchmark for other investments. All other investments must return more than the risk-free rate, or they are a bad choice. Why put money in something that is risky when you can get the same return elsewhere guaranteed? That's why savvy investors use the risk-free rate to compare the returns of different investments. The most famous calculation is the Capital Asset Pricing Model. This formula uses a stock's historic risk, the average return of the stock market and the risk-free rate to calculate what a stock should return per year. This lets investors measure whether a stock is undervalued or overpriced.
Types of Risk
Investors must deal with a number of different risks. One risk is the chance that their investment drops in value on the stock market, known as market risk. Investors also lose money if the company or government they invest in goes bankrupt and can't pay their money back; this is known as default risk. Not all investments are easy to sell. If an investor gets stuck in a poor investment, he may need to offer a discount on the selling price to unload it. This is called marketability risk. Lastly, bond and government debt investments are contracts for a set period of time. If interest rates start to go up and an investor is stuck in his lower-paying contract, he's lost the potential to make money through the higher rates. If he wants to get out of his contract, he needs to sell it for a discount. This is interest-rate risk.
Risk-Free Rate Estimate
The risk-free rate of return must avoid as many risks as possible. It must be an investment that has no chance of a loss through default. It also must be easy to sell so investors can get easily get their money back. Lastly, it must be a short investment so investors don't get trapped. The best investment for these conditions is the short-term government debt of the richest and safest countries. Investors currently use the interest rate on the 3-month U.S. Treasury bill or Germany's 3-month bond. There is no such thing a true risk-free investment, however. A tiny chance exists that these countries could default on their debt or that interest rates could skyrocket during this short period. However, this chance is so small that investors consider these assets risk-free.
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