Understanding stock market terminologies is an essential part of being a successful investor. The concept of risk-free return is a crucial milestone in this regard since it plays a major role in determining which investments offer what kind of risk.
What is a risk-free rate of return?
Often referred to simply as the risk-free rate, the risk-free rate of return is a theoretical concept. It is a hypothetical rate of return earned on an investment that has no risk of financial loss. In other words, it is the return an investor could gain from a zero-risk investment. It is quite a significant measure since it can be used to calculate a benchmark against which other investments can be scaled.
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What are the properties of risk-free return?
The risk-free rate of return has the following properties:
- Risk-free rate of return is a hypothetical concept since all investments carry some amount of risk
- If the potential rate of return is not higher than its risk-free rate, investors will not accept the investment
- Investors must note that the risk-free rate of return is not constant. It keeps changing based on certain microeconomic and macroeconomic variables.
What is the significance of the risk-free rate?
The risk-free rate plays a key role in many financial calculations:
- It can be used to calculate opportunity costs. Investors can decide whether to invest or not by using the risk-free rate as a benchmark.
- In certain scenarios, future cash flows are discounted to the present value. The risk-free rate can be used as the discounted rate.
- The rate can be used to calculate the risk premium and decide whether an investment is worth an additional risk
What are the practical applications of risk-free rates?
The risk-free rate of return has the following real-life applications:
- It can be used to calculate investment valuations and infer whether an investment is overvalued or undervalued
- It can be used to construct portfolios that have balanced risk and returns and hence, become automatically diversified
The risk-free rate of return is a fundamental metric that can have wide-reaching implications. From being a benchmark against potential risks and returns to calculating the cost of capital, it can be a diverse tool that can help your investments.
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