Understanding the Risk-Free Rate of Return: A Comprehensive Guide

In the United States the risk-free rate of return most often refers to the interest rate that is paid on U.S. government securities. The reason for this is that it is assumed that the U.S. government will never default on its debt obligations, which means that the principal amount of money that an investor invests by buying government securities will not be lost. Securities such as Treasury bills, notes and bonds do not protect against interest-rate risk, however. If interest rates go up after an investment is made, then the investor is making less money than before the rate change. There are government securities that have rates which move up with inflation, giving investors some protection against interest-rate risk while keeping their risk-free principal safe. These are called TIPS, or Treasury Inflation-Protected Securities.

Calculate Risk-Free Rates

Step 1

Determine the length of time that is under evaluation. If the length of time is one year or less, then the most comparable government securities are Treasury bills. Go to the Treasury Direct website and look for the Treasury bill quote that is most current. For example, if it is 0.204, then the risk free rate is 0.2 percent.

Step 2

For a time period that is more than one year, but less than 10 years, look up the Treasury notes rate. For example, if it is 2.54, then the risk-free rate is 2.54 percent.

Step 3

If the time period is greater than 10 years, then use the Treasury bond quote. If the current quote is 6.047, as an example, then this risk-free rate will be 6 percent.

Step 4

Look up the TIPS quote on the same site to get a risk-free rate that also protects against rising inflation. For example if the current quote for TIPS is 2.157, then this risk-free rate is 2.15 percent.

Things You'll Need

• Paper

• Pencil

• Access to the Internet