Risk free rate

(noun)

Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.

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 cost of debt is a calculation taking into account the risk premium, the risk-free rate and taxes.
    • The risk -free rate (or Rf) is externally determined from the general market, and is described as the overall cost incurred due to time value of money with no risk whatsoever involved.
    • This is usually derived from a government treasury bond, as it is the most the investment asset in most markets with the lowest possible rate of risk.
    • The credit risk rate is therefore the point of negotiation, and where a risk premium is attached to the debt instrument to compensate the investor in regards to a return (for the risk taken).
    • As a general rule, the larger the debt is the higher the risk rate will be (as all other things being equal, a higher debt is harder to pay back).

  • The Relationship Between Risk and Return and the Security Market Line

    • Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk.
    • In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic risk.
    • The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset's overall sensitivity to market fluctuations or its beta.
    • Mathematically, the capital asset pricing model can be written as: E(Ri) = Rf + β(E(Rm) - Rf), where R is the return, E(R) is the expected return, i denotes any asset, f is the risk-free asset, and m is the market.
    • The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm)− Rf.

  • 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 "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.