The risk-free rate is the return on an investment that carries no risk or zero risk. It is the minimum return that an investor expects from an investment. The investor won’t accept any more risk unless he or she gets a higher return than the risk-free rate.
Since it is the minimum return that an investor expects; the risk-free rate also acts as a benchmark for other interest rates. Meaning, other financial institutions use it to set their interest rates. In the US, the interest rate on a three-month U.S. Treasury bill is usually used a risk-free rate because of the large size and deep liquidity of this instrument.
Nothing is risk-free
Investors expect a certain level of return when they make an investment. However, the actual return they get may not always be the same as their expectations. The difference in the return is due to the risk involved. Since the US Treasury bonds are risk-free, their expected and actual return is the same.
In today’s world, however, no investment carries zero risk, not even the U.S. Treasury bills. Though a government does not default on its obligations, such investments carry some risk for a foreign investor. A foreign investor incurs currency risk while investing in the U.S. Treasury bills. An investor can use hedging techniques like currency forwards and options to diversify such risk. But, it will impact the net return on the investment.
A risk-free rate, however, differs from investor to investor. Like, for a foreign investor, the U.S. Treasury bills carry some currency risk. But, if the same investor invests in the govt. securities in their home country, like a Swiss or German T-bill, such an investment would carry no currency risk.
Though an investor can overcome currency risk, there are two more risks that can’t be avoided. First is the inflation risk, where the actual returns are lower due to inflation over time. Another risk is the interest-rate risk, i.e., the Treasury prices fall when the interest rate rises and vice versa.
Why it’s important?
A risk-free rate serves as a foundation for all other types of investments, including the cost of equity. Since it carries no risk, all other investments, which carry some amount of risk, must offer a higher return to attract investors. So, other investments usually add a risk premium to the risk-free rate to come up with an interest rate.
How big the risk premium is, depends on the risk that the investment carries. For example, a corporate bond from a blue-chip company would carry a smaller risk premium compared to the one from a startup.
Additionally, the risk-free rate is an important input for calculating other important financial components, like the cost of equity, which determines the firms weighted average cost of capital (WACC). Also, it is a fundamental component of the Black-Scholes option pricing model, modern portfolio theory and the capital asset pricing model (or CAPM).