Understand the concept and importance of Risk-Free Rate
The risk-free rate is one of the most fundamental components of modern-day finance. It is the theoretical rate of return of an investment with zero risks. An investor would not accept further risks unless they get a higher rate of return than the specified risk-free rate.
As stated earlier, the risk-free rate is a theoretical concept. It is only used for calculation purposes because, in actuality, all investment options are subject to risk and volatility. The value of a risk-free rate is calculated by subtracting the current inflation rate from the total yield of the government treasury bond matching the investment duration.
So, the formula to calculate the risk-free rate of return can be written as.
Risk-free Rate of Return = ( 1 +Government Bond Rate + Inflation rate) – 1
What is the importance of the risk-free rate?
The risk-free rate acts as a foundation for the cost of capital calculations. The cost of capital is calculated by summing up the risk-free rate of return with a specific risk premium. The size of the risk premium added to the risk-free rate of return will depend on the risk carried by that particular investment. For instance, a corporate-level bond such as one from a blue-chip company would certainly carry a much lesser risk premium compared to that from a small business or startup.
The risk-free rate is also applied in calculating the cost of equity using the capital pricing asset model (CAPM). These are important factors that are used to calculate the weighted average cost of capital (WACC). It is also a fundamentally important factor used for calculation in the Black and Scholes option pricing model and the modern portfolio theory.