A risk-free rate of return refers to the expected return on investment on an investment that carries no risk. It can be compared with the rate of return on other investments in order to assess whether the rate of return is good enough to justify making such an investment. The rate of return refers to the amount of money that an investor can expect to make on his investment.
Investors invest their money for the purpose of earning returns on it. Returns can come in the form of interest, in the case of a certificate of deposit, savings account or treasury bond. Returns can also come in the form of dividends, which are cash payments issued to shareholders of a company in order to distribute earnings the company has. When a stock is owned, returns can also come from an increase in the value of the stock, which causes the share price to rise.
The rate of return is one factor investors use when determining what to invest in. When there are two investments, one of which has a higher return on investment or rate of return, it makes sense to invest in the investment vehicle that will provide a higher income or return on the investment. The other important factor, however, is how risky the investment is.
Nearly every investment has some degree of risk. The risk refers to the chance that some or all of the money will be lost. With a stock, for example, the risk is that the share price will decrease or that the company will go bankrupt and the shares will end up being worth nothing, resulting in a complete loss of the investment. With bonds, the risk is that the bondholder will default.
Higher risk investments must have a higher rate of return to be worth purchasing. Low risk investments, such as savings accounts, on the other hand, can offer a lower interest rate since there is little to no risk of the investor losing the money he has put in. A risk-free rate of return thus refers to the return on investment in an investment that has zero risk.
In reality, a risk-free rate of return is a hypothetical concept. There are essentially no investments in which there is absolutely zero risk of loss. In generally accepted terms, the risk-free rate of return is determined by evaluating the rate of return paid on a three-month United States Treasury bill within the United States. Since a Treasury bill is a loan to the US government, there is little risk of default and thus the investment is considered to be one of the lowest risk investments available and the closest thing to a risk-free rate of return possible.