If you want to work in finance, whether in corporate finance or market finance, you will no doubt be confronted with the notion of risk free rate. In fact, the risk-free rate is the starting point for almost all calculations of interest rates or returns and therefore of the rates charged by investors. It is therefore used in the debt and equity markets but also in private equity or M&A.
In this post, we will explain everything you need to know about the concept of a risk-free rate: definition, formula or uses. Let’s get started.
Risk Free Rate: All You Need to Know
What is Risk Free Rate?
The risk free rate is the rate of return for an investment considered to be safe, that is to say without any risk of default.
This means that you have no risk of the borrower going bankrupt and therefore not being able to repay their loan.
The concept of risk free rate is therefore closely linked to what is called in finance the risk-return ratio, or risk-profitability, which symbolizes the concept of remuneration for risk.
This notion is based on the fact that the more an investment is considered as risky, the more it must bring a high profitability to convince investors.
Here is an example: if you have $100 to invest and you have the choice between two investments in two companies, A and B, which both promise you 10% profitability but Company A is very strong, while Company B is at much higher risk. Why would you go invest in company B and take more risks for similar profitability?
Thus, to convince you to invest in it, company B will have to offer you a higher profitability than company A, for example 15% instead of 10%. After that, it will be up to you to see if you are ready to take more risks for more returns.
We can therefore summarize the principle of any financial investment as follows: more risks = more returns.
Now that we have seen this notion of risk remuneration, the notion of risk-free rate becomes much more natural: it is the return that you can obtain for an investment with a zero level of risk.
What are the uses of the risk free rate
Now that we have seen what the risk free rate is, let’s see what it is for.
Calculate your Cost of Equity
The first use of the risk-free rate is to calculate Cost of Equity. Indeed, as we have seen, a rate of return corresponds to a certain level of risk. Consequently, each investment that presents a minimum risk can be broken down into a sum of two rates: the risk free rate and an additional return to remunerate the additional risk.
Thanks to this reasoning, it becomes much easier to define the components of a cost of equity:
Cost of Equity = Risk free rate + Risk premium
Now that you know the above formula, you can calculate the required return on any stock, bond, or other financial product.
So, all you have to do is define the risk level of a company, look at how the financial markets pay an equivalent level of risk, and add the risk-free rate to it to obtain the cost of equity that interests you.
This method is mainly used by brokers and investment banks in both the equity and bond markets since the yield on a bond can be split in exactly the same way.
To establish benchmarks
The risk-free rate can also be used to establish benchmarks. Indeed, in asset management, the objective of a manager is to grow his portfolio in order to obtain the best possible return while respecting the framework of his management mandate.
However, it takes a little more subtlety to assess a manager’s financial performance than just saying “the biggest return possible”.
What do you think of a manager who posts a performance of 3% if the risk-free rate is also 3%? It’s not that great, isn’t it?
It is for this reason that most financial performance is calculated on the margin generated above the risk-free rate. Otherwise why not just put your investment in a risk free product and get the same return?
Establish the yield of certain derivative products and financial contracts
Exactly as we have broken down the Cost of Equity into different components which include the risk-free rate; investment banks, when they offer financial products to their corporate clients, often set the price of these products based in particular on the risk-free rate.
Here we are not talking about prices in euros, dollars or pounds, but rates.
The first components of these financial products are loans. Unlike a loan for an individual, when an investment bank offers a loan rate to a corporate client, it never indicates a fixed interest rate.
How to choose and calculate your risk-free rate?
Now that you know what the risk-free rate is and what it is for, you still have to choose this rate. In fact, there are several ways to choose your risk-free rate and we’ll walk you through the three main ones.
Using government bonds
Now that you know the definition of the risk-free rate, namely the rate of return on an investment considered safe, you still have to find such an investment.
The first possibility is quite simply to take the interest rate paid by government bonds considered to be non-risky. In general, these are therefore the most developed and financially stable States: United States, Germany, Japan, France, United Kingdom, etc.
It is in fact considered that these States are not at risk of defaulting and will therefore always pay their debts.
Be careful, however, there are government bonds of different maturities, which therefore correspond to the duration of the loan corresponding to this obligation: 3 months, 6 months, 1 year, 2 years, 5 years, 10 years, etc.
What are the limitations of the risk free rate?
The main limitation of the risk-free rate concerns the fact of choosing government bonds to define it. Indeed, it is more and more frequent to see the most financially sound states borrowing at negative rates. In this case, it is difficult to use the rate of a government bond, such as an OAT in France, to define its risk-free rate.
The second difficulty is precisely choosing the right reference. The reference you choose may depend on your geographic location, the currency you use and the duration chosen.
Thus, you are not going to use the Japanese government borrowing rate to define a risk-free rate in India; it wouldn’t make sense.