Risk-free return
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Risk-free return is the rate of return that is guaranteed with no associated risk of loss of principal. It is the rate of return on an investment that is considered to be certain, and is often used as a benchmark for other investments to compare performance against. It is typically used by portfolio managers and investors to evaluate the performance of various investments. The rate of return for a risk-free return is generally very low since the security or asset carries no risk of loss. It is considered to be the ideal rate of return for investors who want to preserve their capital and avoid any risk of loss.
Example of risk-free return
- Treasury bills: Treasury bills (T-bills) are short-term debt obligations issued by the U.S. government with a maturity date of less than one year. These securities are considered risk-free since they are backed by the full faith and credit of the U.S. government and carry no default risk. The rate of return on T-bills is typically very low and is the benchmark for other risk-free investments.
- Bank savings accounts: Bank savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to certain limits, and therefore carry no risk of loss. These accounts generally offer very low interest rates, but are a safe place for investors to park their money and earn a risk-free return.
- Money market funds: Money market funds are mutual funds that invest in short-term debt securities, such as T-bills, commercial paper, and certificates of deposit. These funds are considered to be relatively safe and offer low returns, making them ideal for investors who want to earn a risk-free return.
When to use risk-free return
Risk-free return is often used by investors and portfolio managers as a benchmark for other investments. It can be used in the following situations:
- When an investor is looking to preserve capital and avoid any risk of loss.
- When an investor wants to compare the performance of various investments against a guaranteed rate of return.
- When setting an expected rate of return on a portfolio or investment.
- When determining the cost of capital for a business or project.
- When determining the rate of return for an annuity or bond.
Types of risk-free return
- Treasury Bills: Treasury bills are short-term government debt securities with maturities of less than one year. They are considered to be risk-free investments since they are backed by the full faith and credit of the U.S. government and are highly liquid.
- U.S. Savings Bonds: U.S. savings bonds are a type of debt security issued by the U.S. government. They are considered to be risk-free investments since they are backed by the full faith and credit of the U.S. government and are highly liquid.
- Certificates of deposit (CDs): Certificates of deposit (CDs) are time deposits at a bank. They are considered to be risk-free investments since they are FDIC-insured, meaning that the deposits are guaranteed up to the maximum amount allowed by law.
- Money market funds: Money market funds are mutual funds that invest in short-term debt securities with maturities of less than one year. They are considered to be risk-free investments since they are low-risk investments that provide a steady stream of income.
- Government bonds: Government bonds are debt securities issued by the U.S. government. They are considered to be risk-free investments since they are backed by the full faith and credit of the U.S. government.
- Bank deposits: Bank deposits are funds held in a bank account. They are considered to be risk-free investments since they are FDIC-insured, meaning that the deposits are guaranteed up to the maximum amount allowed by law.
Advantages of risk-free return
- The main advantage of a risk-free return is the assurance of not losing the principal amount invested. This can be particularly beneficial for investors who prioritize capital preservation, such as retirees or those saving for long-term goals.
- A risk-free return also eliminates the need to assess the risk of an investment, allowing investors to compare potential returns between investments without considering associated risks. This can make it easier to identify the most attractive investments in a portfolio.
- In addition, the low rate of return associated with risk-free investments reduces the potential for volatility and short-term losses. This can be beneficial for investors who are looking for a steady and reliable rate of return over the long-term.
- Finally, risk-free returns can also help investors to diversify their portfolios by providing a steady source of returns. This can help to reduce overall portfolio risk, as well as provide a source of income when markets are volatile.
Limitations of risk-free return
Risk-free return is considered to be the ideal rate of return for investors who want to preserve their capital and avoid any risk of loss, however, it has certain limitations. These include:
- Low rate of return: The rate of return for a risk-free return is generally very low since the security or asset carries no risk of loss. This means that investors may not be able to achieve their desired rate of return if they are looking for higher returns.
- Limited availability: Risk-free returns are not always available, as they are typically tied to government bonds, which may not be issued in all countries.
- Lack of diversity: Risk-free returns are often tied to one particular asset class, such as government bonds, which limits the diversity of investments available to investors.
- Inflation risk: Risk-free returns often do not keep up with inflation, which means that investors may not be able to maintain their purchasing power over the long term.
In addition to the risk-free return approach, there are other ways for investors and portfolio managers to evaluate the performance of various investments. These include:
- The Modern Portfolio Theory (MPT) which evaluates the risk and return of a portfolio in relation to the overall market. MPT suggests diversifying a portfolio across multiple asset classes to minimize risk and maximize return.
- The Capital Asset Pricing Model (CAPM) which is used to evaluate the expected return of a security based on the risk-free rate and the market risk premium.
- The Sharpe ratio, which measures risk-adjusted returns by taking into account the volatility of an investment.
- Value at Risk (VaR) which is a measure of the potential losses of an investment over a given period of time.
- Monte Carlo simulations which are used to analyze the impact of market volatility and other risks on investments.
In summary, there are a variety of approaches that investors and portfolio managers can use to evaluate the performance of their investments. The risk-free return approach is one such approach, but it is important to consider other approaches such as the Modern Portfolio Theory, CAPM, the Sharpe ratio, Value at Risk, and Monte Carlo simulations to gain a comprehensive understanding of an investment’s potential returns and risks.
Suggested literature
- Damodaran, A. (1999). Estimating risk free rates. WP, Stern School of Business, New York.
