risk-free rate

(noun)

The default rate of return attached to a 'risk free' asset, such as a treasury bond. While nothing is completely risk free, these assets are as close to minimal risk as possible and represent the lowest practical rate of return.

Related Terms

Examples of risk-free rate in the following topics:

  • Problems with WACC

    • To calculate cost of debt, we add a default premium to the risk-free rate.
    • This default premium is the return in excess of the risk free rate that a bond must yield.
    • It will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises) .
    • To produce the most accurate result, we must take this risk-free rate from a bond containing a similar term structure to our company's debt.
    • Risk-free rates are typically approximated from U.S.

  • The Cost of Debt

    • The credit risk for a certain class of a company's debt requires a premium on return of 5%.
    • The risk free rate is 5% and the corporate tax rate is 20%.
    • In practice, the interest rate paid by the company can be modelled as the risk-free rate plus a risk component, taking into account credit risk; which is the amount of risk incurred by taking on more leverage in capital structure .
    • Thus, for profitable firms, debt is discounted by the tax rate .
    • Cost of debt equals the interest rate of the debt (composed of the risk-free rate and a credit risk premium) times one, minus the corporate tax rate.

  • Defining the Security Market Line

    • The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.
    • The Y-intercept of the SML is equal to the risk-free interest rate.
    • Recall that the risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
    • When used in portfolio management, the SML represents the investment's opportunity cost -- i.e., investing in a combination of the market portfolio and the risk-free asset.
    • The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.

  • The Capital Asset Pricing Model

    • The capital asset pricing model helps investors assess the required rate of return on a given asset by measuring sensitivity to risk.
    • This model focuses on measuring a given asset's sensitivity to systematic risk (also referred to as market risk) in relation to the expected return compared to that of a theoretical risk-free asset.
    • All this really means is that the CAPM tries to measure the risk the market will offer the asset compared to the risk-free rate, and make sure the expected return will offset that risk.
    • On the left side of the equation below, you have an assessment of the overall risk relative to a risk-free asset.
    • On the right side, you have the overall return (similarly relative to a risk-free asset).

  • Expected Risk and Risk Premium

    • Systemic risk is the risk associated with an entire financial system or entire market.
    • The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk free rate.
    • The difference between the return of an asset in question and that of a risk-free asset -- for instance, a US Treasury bill -- can be interpreted as a measure of the excess return required by an investor on the risky asset.
    • The risk premium, along with the risk-free rate and the asset's Beta, is used as an input in popular asset valuation techniques, such as the Capital Asset Pricing Model.
    • Beta is a measure that relates the rate of return of an asset, ra, with the rate of return of a benchmark, rb.

  • The Cost of Common Equity

    • -- Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.
    • The CAPM shows that the cost of equity is equal to the risk free rate plus a premium expected for risk.
    • In the dividend growth model, dividends paid to common shareholders along with the overall expected growth rate are used to calculate a cost for the common stock.
    • The risk premium is the additional rate that must be paid to common shareholders above what is paid to bond holders, given the amount of risk carried by the equity.
    • Expected return for a security equals the risk-free return for the market plus the beta for the security times its risk premium.

  • The "Bond Yield Plus Risk Premium" Approach

    • Simply put, the yield on a bond is the rate of return received from the investment.
    • This is also referred to as the internal rate of return (IRR).
    • The equity risk premium is essentially the return that stocks are expected to receive in excess of the risk-free interest rate.
    • It can be very difficult to get an accurate estimate of the risk premium on an equity, having a duration of roughly 50 years, using a risk-free rate of such short duration as a 10-year Treasury bond.
    • A hypothetical graph showing yield to maturities (or internal rates of return) for corresponding present values.

  • Measuring Country Risk

    • International investors, buying foreign bonds, can experience a currency exchange rate risk, an interest-rate risk, a borrower default, and/or a country risk.
    • Consequently, the interest rate is comprised of the risk-free interest rate and risk premium.
    • Risk-free interest rate reflects the market interest rate with a zero default rate.
    • Investors believe the U.S. government debt is risk-free because the U.S. government can increase taxes or print money to repay the bonds.
    • If a country possesses a low score, then analysts and economists would add a large risk premium to the risk-free interest rate.

  • Drivers of Market Interest Rates

    • Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.
    • In a free market there will be a positive interest rate.
    • The greater the risk is, the higher the market interest rate will get.
    • However, economists generally agree that the interest rates yielded by any investment take into account: the risk-free cost of capital, inflationary expectations, the level of risk in the investment, and the costs of the transaction.
    • where in is the nominal interest rate on a given investment, ir is the risk-free return to capital, pe = inflationary expectations, i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S.

  • Default Risk and Bond Price

    • For instance, the U.S. government has little risk of default, and investors call U.S. securities default-risk-free instruments.
    • Economists call the difference between the interest rate on the U.S. government bonds and corporate bonds the default risk premium.Investors add default risk premium to a risk-free investment, so they can invest in "risky" bonds because they earn a greater return.
    • Rating companies such as Standard & Poor's Corporation and Moody's Investor Service assess the default risk for corporations.
    • Thus, the demand for corporate bonds falls while the demand for government bonds rise because the investors consider the government bonds default-free.
    • Taking the difference between the government bond and corporate bond interest rates, we can calculate the risk premium.