A risk-free rate of return is a highly specialized term that is used in financial matters. This word refers to the rate, which indicates the level of profitability that is achievable when using a specific financial instrument.
You need to understand that in practice there are virtually no risk-free ways to increase capital. Any attempt to invest in order to further generate income results in the presence of a certain probability of financial loss. However, experts recommend always calculating the rate, without neglecting this relatively simple action. The result allows you to compare several financial instruments and among them choose the one that represents the least potential danger to the investor.
Indicator Features
Now you know what a risk-free rate of return is. However, familiarization with the nuances that this term carries in itself will not be superfluous.
So, entering into any transaction, potential investors want to know as accurately as possible the level of profitability and risks that the project carries. To clarify these indicators, some evaluation criteria are used, in which experts use the discount rate, as well as the direct capitalization ratio.
When calculating each of the above indicators, the risk-free rate of return plays the most important role. In turn, it is divided into genuine and national. The difference between the two species is relatively simple. The national risk-free rate of return takes into account the current rate of inflation in the state, the true one reflects a coefficient that takes into account typical types of investments that have the least risks.
How is everything really?
The name "risk-free" misleads some ordinary people. It creates the illusion that any risks are completely absent. However, this is not at all true. Any assets carry certain risks. Government securities are considered the least risky . However, even they carry a certain financial risk associated with changes in rates 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 assess their likelihood.
Don't let the name fool you. The financial market is designed in such a way that any investment carries a probability of loss.
Value
The risk-free 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.
A risk-free rate of return on bonds allows you to assess the level of income. For example, if an investment portfolio makes 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 with a high probability will refuse to make a transaction that is obviously unprofitable for him.
When it comes to investments, the discount rate should take into account the risk premium, as well as the indicator of the risk-free rate of return on the bond, the value of which is difficult to overestimate. This term often appears in the modern economy.
What do you need to know?
When it comes to profitability, you need to consider many parameters. 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.
- Characteristics of income.
- Features of attachments.
- Discount rate.
- The amount of potential costs.
For example, using the discount rate, evaluate the potential profit margin. In addition, the above indicator plays the role of a kind of indicator that demonstrates the effectiveness of financial injections. Its main function is to be able to assess the potential size of investments to obtain the desired level of income.
Relevance
The risk-free rate of return is used in the calculation to reduce the likely risks. However, one must think realistically and understand that avoiding them completely will not work.
Among the risk factors are the following:
- unpredictable circumstances;
- probability of price changes in the future;
- political change;
- interest rate adjustments.
The above factors, no one can predict in advance. That is why experts are developing various ways to minimize or even eliminate the consequences of unforeseen circumstances. For example, if it is likely that bonds will depreciate, the investor may sell them and benefit from this transaction. If the risk is assessed as insignificant, the conclusion of such transactions can be avoided.
Criterias of choice
Before calculating the above indicator for a specific date, you need to clarify which assets will be discussed. First of all, a potential investor must clearly understand which financial instruments carry the least amount of risk.
Before calculating a risk-free rate, you need to check the asset for compliance with three criteria, which will be listed below:
- First of all, they determine the potential profitability that the investor can get in the future.
- Minimum risk level relative to cash loss. This paragraph also refers to unforeseen circumstances.
- Circulation time. This characteristic refers to the period during which the enterprise operates.
Now you know the principle by which assets are selected for subsequent calculations of a risk-free rate of return. This is necessary because it is too laborious to carry out such actions for each asset. That is why you need to take time to select the most attractive for potential investors.
Features of the calculations
If you believe the practice, experts argue that the risk-free ones usually include such securities that are able to guarantee a potential investor a profit and minimize the likelihood of losing funds.
Another fact that is important to consider in the calculations is curious. Securities issued by legal entities do not fall into the category of securities. This category includes only those financial instruments that the government offers. However, no one talks about the complete absence of risks. Refinancing, as well as changes in interest rates need to be taken into account.
Formula
So, for the calculation we use the formula created in the last century:
P H = P p + P inf + P p * P inf
P p = P H - D inf / 1 + D inf
Symbols need to be clarified in order to make the formula more understandable to the simple reader:
- P H is the nominal rate;
- R p - real rate;
- D inf - inflation index (annual inflation rate).
Now you know the methods for selecting and calculating a risk-free rate of return. Using this indicator in practice, it is possible to calculate the likelihood of risks. Based on the data obtained, investors, as a rule, make decisions on the feasibility of transactions.
Risk-free rate in Russia
To assess this, indicators in the Russian Federation use several different tools:
- State bonds of Russia.
- Refinancing rate set by the Bank of Russia. It is expressed as a percentage. The established refinancing rate determines the percentage of other financial institutions that can be credited to the Bank of Russia.
- Interbank loan rate. There may be several. For example, it may be the average annual interest rate, which will be guided by large banks when registering mutual debts. I must say that interbank rates are short-lived. In addition, the risk-free rate should take into account the probability of non-return, therefore, the above indicator cannot be considered completely reliable.
Purpose 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 their activities. It is from this value that the starting point of all further calculations begins. It allows you to calculate the minimum potential profit that can bring various financial instruments. If, according to the calculations of the investor, it is likely that the investments will bring an income below the established risk-free rate, the transaction is deemed unprofitable.
For this reason, when evaluating investments in the discount rate, they include 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, industry and production.
Alternative metric
As a risk-free rate of return, as a rule, a similar indicator for OFZ is used. These are securities issued by the state. However, even they carry a certain probability of occurrence of risks:
- Reinvestment rate. This means that it is impossible in advance to predict the behavior of the investor regarding the actions with the profit received at the end of the bonds. For example, he can re-invest his own profit. The risk of reinvestment is relevant if the maturity of securities is less than the period for which another participant in the stock market invests his own money.
- Interest rate. This indicator may change at any time. If an investor invests his own financial resources for a period not exceeding the maturity, then such an investment may fall under the definition of risk-free. However, it is impossible to know exactly what interest rate will be set at the time of repayment of the asset.
Under what conditions can an asset be considered risk-free?
This is a very important nuance that allows you to correctly make calculations.
So, several conditions should coincide, namely:
- The presence of specific profitability, which can be found even before the conclusion of the transaction.
- Minimal risk of capital loss.
- A long circulation period, which usually coincides with the life of the company.
Given the above conditions, it is easy to conclude that securities that guarantee stable profit and a low probability of loss of investments are often recognized as risk-free assets. For this reason, the list of risk-free assets present on the stock market is often limited only to government securities. In turn, this can create increased demand for this variety of assets and increase their value. That is why investors pre-conduct thorough calculations before concluding any transactions.