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Is the Risk-Free Rate of Return Truly Risk Free?

Updated: Jul 5, 2023

Is the risk-free rate truly risk-free?

The risk-free rate is a theoretical concept that represents the return on an investment that has no risk of default or loss of principal. It is often used as a benchmark for valuing other assets, such as stocks and bonds, by calculating their risk premium over the risk-free rate. The risk-free rate is also an important input for the capital asset pricing model (CAPM), which estimates the expected return of an asset based on its systematic risk.

But how do we measure the risk-free rate in practice? And is it really risk-free?

One common way to estimate the risk-free rate is to use the yield on government bonds, such as U.S. Treasury bills or bonds, which are considered to have negligible default risk. However, this approach has some limitations and challenges.

First, government bonds are not truly risk-free, as they are subject to interest rate risk and inflation risk. Interest rate risk is the possibility that the bond's value will decline when interest rates rise, as bond prices and interest rates move inversely. Inflation risk is the possibility that the bond's purchasing power will erode over time due to rising prices. These risks affect both the nominal and real returns of government bonds.

Second, government bonds have different maturities and durations, which affect their sensitivity to interest rate changes and liquidity. The maturity of a bond is the time until it pays back its principal, while the duration of a bond is a measure of how long it takes to recover the present value of its cash flows. Generally, longer-maturity and longer-duration bonds have higher interest rate risk and lower liquidity than shorter-maturity and shorter-duration bonds. Therefore, using different maturities of government bonds as proxies for the risk-free rate may result in different estimates.

Third, government bonds are subject to supply and demand factors that may distort their yields and prices. For example, during periods of financial stress or uncertainty, investors may flock to government bonds as a safe haven, driving up their demand and lowering their yields. Conversely, during periods of economic expansion or optimism, investors may shift to riskier assets, driving down their demand and raising their yields. Moreover, government policies and interventions, such as quantitative easing or fiscal stimulus, may also affect the supply and demand of government bonds.

Therefore, the risk-free rate is not really risk-free, but rather an approximation based on observable market data. It may vary depending on the choice of proxy, maturity, currency, and market conditions. Investors and analysts should be aware of these limitations and challenges when using the risk-free rate for valuation or asset allocation purposes.

Is it better to use the real or nominal risk-free rate?

Egypt's central bank rate is 16%, but inflation is running at 32% resulting in real rates being deeply negative. Egypt is the second largest economy in Africa (Nigeria is #1) and the 33rd largest globally.

One of the main choices we have to make is whether to use the real or nominal risk-free rate. The real risk-free rate is the return on an investment after adjusting for inflation. The nominal risk-free rate is the return on an investment before adjusting for inflation. The difference between the two is the expected inflation rate.

For example, suppose that a one-year government bond pays 2% interest per year. If we expect inflation to be 1% over the next year, then the real risk-free rate is 1% (2% - 1%) and the nominal risk-free rate is 2%. If we expect inflation to be 3% over the next year, then the real risk-free rate is -1% (2% - 3%) and the nominal risk-free rate is still 2%.

So which one should we use? The answer depends on the context and purpose of our analysis. Generally speaking, we should use the real risk-free rate when we are dealing with real cash flows and real values. For example, if we want to calculate the present value of a project that generates a constant stream of cash flows in real terms (i.e., adjusted for inflation), then we should discount those cash flows using the real risk-free rate.

On the other hand, we should use the nominal risk-free rate when we are dealing with nominal cash flows and nominal values. For example, if we want to calculate the present value of a bond that pays a fixed amount of interest and principal in nominal terms (i.e., not adjusted for inflation), then we should discount those cash flows using the nominal risk-free rate.

Using the appropriate risk-free rate can make a significant difference in our valuation and decision-making. For instance, if we use a real risk-free rate of 1% instead of a nominal risk-free rate of 2% to discount a bond that pays $100 in one year, then we will get a higher present value of $99.01 instead of $98.04. This means that we will be willing to pay more for that bond, or equivalently, accept a lower yield.

In summary, there is no definitive answer to whether it is better to use the real or nominal risk-free rate. It depends on what kind of cash flows and values we are working with, and what kind of assumptions and expectations we have about inflation. The key is to be consistent and transparent in our choice and application of the risk-free rate.

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