How to Calculate the Risks-free Rate of Return
Have you ever heard about a risk-free rate? The degree of returns attributed to an investment provides a guaranteed return with zero risks.
Too good to be true?
Indeed, the risk-free rate does not technically exist; even the safest investments carry some level of risk. In practice, the risk-free return is used as a “theoretical” benchmark above which investments that have risk should perform. In Investment jargon, the difference between the expected returns of a particular investment and the risk-free rate is called the risk premium or the risk discount, depending on if the returns are higher or lower.
Let’s look at these two cases:
– Market risk premium is the risk taken above the risk-free rate with the expectation of higher returns.
– A risk discount is a situation in which an investor is willing to accept lower expected returns in exchange for lower risk or volatility.
How to select a Risk-Free Rate
The most relevant risk-free benchmark must be identified based on three main features:
- the country (US, Europe, etc.). It is common practice to refer to benchmarks identified by Central Banks of developed countries
- the sector you are investing in (Finance, Real Estate, Business, etc.)
- the timeline of the investment
In the US, the US Treasury Bill is seen as a good example of a risk-free investment since the government cannot default on its debt. However, the most suitable benchmark should change depending on the tenure (time period) of your investment:
– the T-bill is suitable for investments under one year
– US Treasury Notes are suitable for Investments between 1 and 10 years
– US Bond is suitable for Investments over 10 years
How to Calculate the Inflation-adjusted Risk-Free Rate
Inflation is a hidden tax. It can have a major impact on the performance of our investments. As such, it is important to consider it and, when possible, calculate the Inflation-adjusted risk-free rate. This can be calculated by subtracting the current inflation rate from the Risk-Free Return.
- a) Formula: Risk-Free Benchmark – Inflation.
For example, if the risk-free rate of return is 3% and the inflation rate is 2%, the real risk-free rate of return is 1% (3% – 2% = 1%).
Because the risk-free rate is low in the first place, the real return can sometimes be negative,
particularly in times of high inflation.
- b) Alternative formula: (1+ Risk-Free benchmark) / (1+ Inflation Rate) – 1
For example, using the same inputs, with a risk-free rate of 3% and the inflation rate is 2%, the real risk-free rate of return is 0.98% [(1+3%)/(1+2%)-1].
How to Calculate Risk Premium
Formula: Estimated Return – Risk-Free Return
This model makes a key assumption that current valuation multiples are roughly correct. Let’s look at an Investment with estimated returns of 6%:
Estimated Return of your investment:
Risk-Free Rate of Returns (inflation-adjusted):
Before choosing an investment, I appreciate the idea of looking at the most suitable benchmark and possibly comparing it with other investments with higher or lower returns. It is also important to clarify how the investment returns take into account inflation: are the returns inflation-adjusted? On this topic, check out How to calculate the Real Rate of Returns, Inflation Adjusted.
Ultimately, the degree to which you are willing to trade risk for return depends on your particular risk tolerance, while the right Investment is the one that matches your risk tolerance, your timeline and your goals.