Definition: Risk-free rate of return is an imaginary rate that investors could expect to receive from an investment with no risk. Although a truly safe investment exists only in theory, investors consider government bonds as risk-free investments because the probability of a country going bankrupt is low.
What Does Risk Free Rate of Return Mean?
What is the definition of risk-free rate? The risk free rate is minimum return an investor is willing to accept at an investment level. In other words, if the risk of an investment goes up, investors must receive a higher return in order to entice them to make the investment.
Risk-free investments have an actual return that is equal to the expected return because there is no default risk. Furthermore, a risk-free investment generates lower returns that any other investment that incorporates a higher risk and should reward investors with higher returns. The relationship between the interest rate for zero risk investments and options depends on the correlation between the interest rate and the options.
If the correlation is positive – high-interest rates and increased index values – it can be shown that the value of the put option is reduced, while the opposite is true for the price of call options. If the correlation is negative – high-interest rates and lower index values – the price of the put option increases, while the price of call options decreases. The capital asset pricing model (CAPM) uses the risk-free rate as a benchmark above which the assets that incorporate risk should perform.
Let’s look at an example.
Example
Anne is a financial analyst at Margin Securities, and she follows the food industry. Anne believes that one of the stocks she follows is overvalued. Therefore, she decides to use the CAPM model to determine whether the stock is riskier than it should be in relation to the risk-free rate.
Anne knows that the stock has a beta of 0.75, the required return is 7%, and the risk-free rate is 4%. Using the CAPM model, she finds that:
Cost of equity = risk-free rate + beta × (required return – risk-free rate) = 4% + 0.75 (7% – 4%) = 4% + (0.75 x 3%) = 4% + 2.25% = 6.25%
The required return of the stock is 6.25%, which means that investors see a growth potential in the firm since they are willing to accept a higher risk than the risk-free rate to get higher returns.
Summary Definition
Define Risk Free Rate of Return: RFR is achieved by investing in financial products that do not incorporate risk.
