Meaning of Real Risk-Free Rate of Interest
Risk-Free Rate or its other name is the Risk-Free Interest Rate. And the Risk-Free Rate is the rate that one can get without taking any risks. Or, we can say that it is the return on an investment that carries zero risks. However, the concept of zero risks is only theoretical. Because in real-life situations, a risk-free rate does not exist. Since every investment will have at least some amount of risk with it. However, the concept of “real risk-free rate of interest” is slightly different. A rate that has been adjusted for the effect of inflation over the investment time period is the real risk-free rate of interest.
Government securities and bills are the best benchmarks for a risk-free asset because they have no default risk. The chance of the government failing to repay an amount against the bills and securities it issues is extremely low. Hence, we use the risk-free rate equivalent to the interest rate on a three-month U.S.Treasury bill. In case our investment period horizon is long, we generally use the interest rates on U.S. Treasury notes and bonds as the benchmark for the risk-free rates of interest.
Theoretically, an investor will not face any kind of risk while investing in a security. Provided it is risk-free, such as default risk or investment risk. However, if an investor from any country other than the USA decides to invest in the U.S. Treasury bills, bonds, or notes, he will face the currency risk. Any changes in the value of his currency vis-à-vis the US dollar will impact his earnings from the investment. Also, he should take into account the rate of interest corresponding to the time period for which he wants to invest. If he plans to invest for a period of 5 years, he should take into consideration the rate of interest of a Treasury note or a bond for a similar time period for assessment.
What is the Importance of a Real Risk-Free Rate of Interest?
Investors across the world face numerous risks in their investments. The various forms of risks can be related to interest rate risk, liquidity risk, market risk, currency risk, risk of default, country risk, etc. These risks can either downsize an investment or can totally erode it in case of a default or crash. Other than these, one of the major risks that investors face with their investments is the inflation risk.
Negating the Effect of Inflation
The effect of inflation on interest earnings is significant, especially in the case of long-term investments. Inflation per se reduces the purchasing power of the currency or we can say that the intrinsic worth of the currency erodes due to inflation. Hence, inflation risk is a serious risk and no one can avoid this. It will reduce the worth of the investments. For example, suppose we invest in the US $ 10000 in a debt fund in the year 2010 and get back US$ 15000 at the end of the year 2020. We have an interest-earning of $ 5000 in mathematical terms. But it is possible that the $15000 that we get in the present times will not be able to buy us the same quantity of goods that we could have bought for $10000 in the year 2010.
This is the effect of inflation and it makes our investment journey useless or makes the return on our investment look meager or even negative over a long period. An investor will be better off by not making that investment rather than going for it. This is where the concept of the real risk-free rate of interest comes into play. One can calculate/determine or judge the risk-free rate of interest after adjusting it for the effect of inflation at the current rate. If the rate of interest he is earning is still positive, after due adjustment of the inflation rate, then he should go for the investment. In case it turns out to be negative, he should avoid making that investment.
Comparison between Investments
An investor can make comparisons and decide the preferable investments by comparing them with the Risk-Free Rate of Interest. Further to take into consideration the impact of inflation that may see a substantial up move during the period of investment, the comparison can be with the Real Risk-free rate of interest. Both these rates will act as a benchmark or reference point for drawing a comparison and evaluating different investment options. An investor can earn a rate of interest that is risk-free by investing in government securities. In case he is willing to take some risk, he can go for other investment options such as stocks, gold, bank deposits, etc. He can weigh each option based on his risk capacity and the risk premium he will get over the risk-free rate and the returns he will get.
In case the expected returns are much higher than the risk premium at the maturity period, he can go for the investment option. In case it is not so, he can avoid making that investment and look for better opportunities. Or he can simply invest in government security in which the real risk-free interest rate is usually positive.
We use and follow the risk-free rate of interest frequently. It is also known as the nominal risk-free rate of interest. And most often the reference is with the nominal Risk-Free Rate only. But it is absolutely crucial to take into account the effect of inflation on our investments. This will help us to find their true worth. For this, we need to use the values of the real risk-free rate of interest. The metric helps us to understand the true rate of return that we can earn from any investment. Also, it has an important role while doing the CAPM (Capital Asset Pricing Model) calculations, Sharpe ratio calculation, stock, and securities pricing, and many other similar applications. So, basically for all the advanced calculations and analysis, we use this one.
Continue reading – Real vs Nominal Risk-Free Rate
Frequently Asked Questions (FAQs)
A risk-free rate of interest is a theoretical rate of interest that an investor can earn on investment with zero risks. A risk-free rate that has been adjusted for the effect of inflation over the investment time period is the real risk-free rate of interest.
It helps in the following ways:
1. Negating the effect of inflation
2. Acts as a benchmark for making a comparison between different investment options