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Leveraging Risk-Free Rate of Return for Smart Investments

18 Oct 2023

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

Conclusion

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. 

 

Related Articles: What Are Thinly Traded Securities | What is Price Discovery | Difference Between Variance and Covariance | High Priced vs Low-Priced Stocks

 

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