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There are many terms and phrases you should be familiar with as an investor. It doesn't matter what your risk profile or investment horizon is, it is important to stay up-to-date about investing jargon and the various investment options. This is the moment when many investors are unfamiliar with a term they have heard about, but don't know what it actually means. This is the risk-free rate or return.
It's likely that you don't know much about it, or have a lot more questions than you realize.
Is it even possible?
What does it mean?
Which investments are eligible for risk-free returns?
It's important to understand the basics of all this. To do so, we need to answer the fundamental question: What is a risk-free rate for return? So, let's get started.
The risk-free rate is, theoretically speaking, the lowest rate of return that an investor can expect or earn from an investment that has zero risk. Experts consider this a theoretical concept. In practice, there is no investment that has zero risk. All investments involve some risk, even if it is negligible. Investors may not be able to achieve risk-free returns.
However, this term is often used to describe the returns from certain investment options such as the US Treasury bonds or German government bonds. This is because the risk associated in government-backed bonds, such as those issued by the USA or Germany, is low enough to allow the earnings to be considered risk-free.
The risk-free rate is typically composed of three components: the inflation rate in the country, rental rates, and investment risk associated to an investment option. Let's examine these components.
Now you know the simple answer to the question: What is your risk-free rate for return? As an investor, you may have additional questions about how this rate impacts investors like yourself. This is a valid concern. Let's now take a look at the risks-free rate for investors.
Since investments with zero risk are deemed to have risk-free returns, investors will naturally expect higher returns from other options that carry more risk. The risk-free return rate is simply the lowest rate you can expect to receive from market investments.
This risk-free rate is used as a base for other rates such as the cost to equity. It is calculated by adding risk premiums to the market rate of risk-free return. This risk premium is used to account for additional risk that may be associated with certain investment options.
The risk-free rate of interest can be used to calculate the cost of debt. To account for increased risk, a default spread can be added to the risk free rate. The spread is dependent on the credit risk associated to the debt instrument issuer.
You now know the risk-free return rate. This metric can be used to help you make investment decisions. The risk-free rate does not always remain constant. It fluctuates based on different macroeconomic and microeconomic factors. Keep checking the website for the current risk-free rate.
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