What is Risk Free Rate of Return?
A risk free rate of return, often denoted in formulas as rf,, is the rate of return associated with an asset that has no risk (that is, it provides a guaranteed return). It is also commonly referred to as 'risk free return.'
How Does Risk Free Rate of Return Work?
Treasury bills are the most common example of assets that offer a risk-free rate of return. Because the U.S. government has the authority to simply print money, there is virtually no risk that those who lend money to the government (via the purchase of Treasurys) will not receive their interest and principal payments when due.
Why Does Risk Free Rate of Return Matter?
The notion of a risk-free rate of return is a fundamental component of the capital asset pricing model (CAPM), the Black-Scholes option pricing model and modern portfolio theory because it essentially sets the benchmark above which assets that do contain risk should perform. Of course no asset is truly risk free -- there is always at least some possibility, no matter how minute, that the U.S. government would not be able to repay its debt, for example. But that risk is considered so minute as to be virtually zero.
Regardless of the debate over the true statistical probability of default on risk-free assets, it's important to note that the risk-free rate of return is subject to inflation risk, whereby the returns are eaten away by inflation over time. Also, the risk-free rate of return carries interest-rate risk, meaning that when interest rates rise, Treasury prices fall, and vice versa. Fortunately, in periods of rising interest rates, Treasury prices tend to fall less than other bonds do.
