The Risk-Free Rate Of Return

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What is a risk free rate of return’

The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents interest investor expect from an absolutely risk free investment over a specified period of time.

In theory, the risk-free rate is the minimum return an investor expects for any investment because he wouldn’t take on additional risk if the potential return is higher than the risk-free rate.

In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on three-month US Treasury bills is often used as the risk-free rate for American investors.

Breaking down the ‘risk free rate of return’

The definition of a proxy for the risk-free rate of return for this situation should consider a home investor in the market, while negative interest rates can complicate this issue.

Currency Risk

Three-month US Treasury bills is a useful indicator because the market believes that there is virtually no chance of the government defaulting on its obligations. The large size and high liquidity contribute to the perception of security. However, a foreign investor, whose assets are not in dollars incurs currency risk when investing in U.S. Treasury bills. The risks can be hedged using currency forwards and options, but the effect on yield.

Short-term government bills other highly rated countries such as Germany and Switzerland, offer a risk-free proxy rate for investors with assets in euros or Swiss francs. Investors that are in less highly rated countries within the Eurozone such as Portugal and Greece, have the opportunity to invest in German bonds without currency risk. In contrast, an investor with assets in Russian rubles are unable to invest in the high rating of government bonds without any currency risk.

Negative Interest Rates

The flight to quality and away from high-yielding instruments, on the background of the protracted European debt crisis has pushed interest rates to negative territory in countries considered safe, such as Germany and Switzerland. In the United States, inter-party battles in Congress over raising the debt ceiling is sometimes sharply limited the issuance of promissory notes in connection with the lack of supply driving sharply lower prices. The minimum acceptable yield for a Treasury auction equal to zero, and sometimes trade with negative yields in the secondary market. And in Japan’s stubborn deflation led the BOJ to pursue a policy of ultra-low and sometimes negative interest rates to stimulate the economy. Negative interest rates essentially to push the concept of the risk-free return to the extreme; investors are willing to pay to place their money in assets that they consider safe.

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