Risk free rate of return: value, selection and calculation methods

2024 Author: Howard Calhoun | [email protected]. Last modified: 2024-01-02 13:48

The risk-free rate of return is a highly specialized term used in finance. This word is called a rate, which indicates the level of profitability achievable when using a particular financial instrument.

You need to understand that in practice absolutely risk-free ways to increase capital do not actually exist. Any attempt to invest in order to further generate income turns into a certain probability of financial losses. However, experts recommend always calculating the bet, without neglecting this relatively simple action. The result obtained allows you to compare several financial instruments and choose among them the one that poses the least potential danger to the investor.

Features of the indicator

Now you know what the risk-free rate of return is. However, familiarization with the nuances that this term carries in itself will not be superfluous.

So, making any deal, potential investors want to know as accurately as possiblethe level of profitability and risks that the project carries. To determine these indicators, some evaluation criteria are used, for which experts use the discount rate, as well as the direct capitalization ratio.

When calculating each of the above indicators, the most important role is assigned to the risk-free rate of return. In turn, it is divided into genuine and national. The difference between the two kinds is relatively simple. The national risk-free rate of return takes into account the current rate of inflation in the state, the real reflects a coefficient that takes into account typical types of investments that have the lowest risks.

How is it really?

The name "risk-free" misleads some people. An illusion is created that there are no risks at all. However, this is not the case at all. Any asset carries certain risks. Government securities are considered the least risky. However, even they carry a certain financial risk associated with a change in the rate and some other indicators.

Any investor invests his own funds, expecting to make a profit in the future. However, any financial instrument carries risks. The term "risk-free rate" was coined in order to estimate their probability.

Don't let the name fool you. The financial market is designed in such a way that any investment carries the possibility of losses.

Meaning

Risk freeThe rate of return, in fact, is perhaps the main indicator that investors use to make decisions. Based on this indicator, they agree to transactions or, conversely, refuse them.

The risk-free rate of return on a bond allows you to estimate the level of income. For example, if an investment portfolio brings a profit that does not exceed the size of the above indicator, it cannot be called effective. Accordingly, in a similar situation, a potential investor is highly likely to refuse to make a deal that is obviously unprofitable for him.

When it comes to investments, the discount rate must take into account the risk premium, as well as the risk-free rate of return of the bond, the value of which is difficult to overestimate. This term often appears in modern economics.

What you need to know?

When it comes to profitability, there are many parameters to consider. The risk-free rate of return of the Central Bank is not the only one.

In practice, other parameters are no less important, including the following items:

• The value of property owned by the company.
• Income characteristics.
• Features of attachments.
• Discount rate.
• Potential costs.

For example, using a discount rate, estimate the potential profit. In addition, the above indicator plays the role of a kind of indicator that demonstratesefficiency of financial investments. Its main function is to be able to estimate the potential amount of investment to obtain the desired level of income.

Relevance

The risk-free rate of return is used in the calculation to reduce possible risks. However, you need to think realistically and understand that it will not be possible to completely avoid them.

Among the risk factors are the following:

• unforeseen circumstances;
• probability of price changes in the future;
• political changes;
• Interest rate adjustments.

The above factors no one can predict in advance. That is why experts are developing various ways to minimize the consequences that unforeseen circumstances carry, or even eliminate them. For example, if there is a possibility of devaluation of bonds, an investor can sell them and benefit from this transaction. If the risk is assessed as insignificant, such transactions can be avoided.

Selection criteria

Before calculating the above-mentioned indicator for a specific date, it is necessary to clarify what assets will be discussed. First of all, a potential investor must clearly understand which financial instruments carry the least amount of risk.

Before calculating the risk-free rate, you need to check the asset against three criteria, which will be listed below:

• First of all, determine the potentialreturn that the investor will be able to receive in the future.
• The minimum level of risk regarding the loss of funds. Including in this paragraph we are talking about unforeseen circumstances.
• Talking time. This characteristic refers to the period during which the enterprise operates.

Now you know how assets are selected for subsequent calculations of the risk-free rate of return. This is necessary because it is too labor-intensive to carry out such actions for each asset. That's why you need to take the time to select the most attractive ones for potential investors.

Features of calculations

According to practice, experts say that risk-free securities usually include those securities that can guarantee a potential investor a profit and minimize the likelihood of losing funds.

Another interesting fact that is important to take into account in the calculations. Securities issued by legal entities do not fall into the category of securities. This category includes only those financial instruments offered by the state. However, no one talks about the complete absence of risks. You need to take into account refinancing, as well as changes in the interest rate.

Formula

So, for the calculation, a formula created in the last century is used:

P_H=R_r + R_inf + R _R R_inf

R_r=R_H – D_inf/1 + D inf

Condition althe notation needs to be clarified to make the formula more understandable to a lay reader:

• Р_{H – nominal rate;}
• R_{r – real rate;}
• D_{inf – inflation index (annual inflation rate).}

Now you know the methods for selecting and calculating the risk-free rate of return. Applying this indicator in practice, it is possible to calculate the probability of occurrence of risks. Based on the data received, investors, as a rule, make decisions about the appropriateness of transactions.

Risk free rate in Russia

To assess this, indicators in the Russian Federation use several different tools:

1. Russian government bonds.
2. The refinancing rate set by the Bank of Russia. Expressed as a percentage. The established refinancing rate determines the interest rate at which other financial institutions can receive loans from the Bank of Russia.
3. The rate on interbank loans. There may be several. For example, it can be an average annual interest rate, which large banks will be guided by when registering mutual debts. It must be said that interbank rates are short-lived. In addition, the risk-free rate must take into account the probability of non-return, so the above indicator cannot be considered completely reliable.

Purposes of application

The risk-free rate of return of the Central Bank of the Russian Federation is one of the most important indicators that investors use in theiractivities. It is from this value that the starting point of all further calculations begins. It allows you to calculate the minimum potential profit that various financial instruments can bring. If, according to the investor's calculations, there is a possibility that the investment will bring income below the established risk-free rate, the transaction is considered unprofitable.

For this reason, during the investment evaluation period, the discount rate includes not only such a rate, but also an insurance premium for potential risk. The latter indicator is quite extensive and can cover various types of existing risks, including technical, macroeconomic, sectoral and production.

Alternative indicator

As a rule, a similar indicator for OFZ is used as a risk-free rate of return. These are securities issued by the government. However, even they carry some risk:

• Reinvestment rate. This means that it is impossible to predict in advance how an investor will behave in relation to the actions with the received profit after the expiration of the bonds. For example, he can reinvest his own profits. Reinvestment risk is relevant if the maturity of the securities is less than the period for which another participant in the stock market invests his own money.
• Interest rate. This figure may change at any time. If an investor invests its own funds for a period not exceeding the maturity date, then such an investment may fall under the definitionrisk-free. However, it is impossible to know exactly what interest rate will be set at the time the asset is redeemed.

Under what conditions can an asset be considered risk-free?

This is a very important nuance that allows you to make calculations correctly.

So, several conditions must match, namely:

• Availability of a specific profitability, which can be known even before the conclusion of the transaction.
• Having a minimal probability of capital loss risk.
• Long circulation period, which usually coincides with the life of the company.

Given the above conditions, it is easy to conclude that risk-free assets are often recognized as securities that guarantee stable profits and a low probability of losing investments. For this reason, the list of risk-free assets present on the stock market is often limited to only government securities. In turn, this can create increased demand for this type of asset and increase their value. That's why investors do their due diligence before making any trades.