A risk-free rate is the rate of interest a borrower has to pay or an investor expects to earn on an asset carrying zero risks. It is the minimum return that an investment must give over a period to be profitable. If you keep the money in a fixed deposit, you will get an assured interest. A risk free rate is like that and can be calculated by using a mathematical formula.
Generally, the central bank of a country guarantees a risk-free rate on government bonds or bank deposits.
It is assumed that bonds of developed countries do not have a default risk. There is a currency risk when investing in bonds or deposits in a different currency. For this reason, investments in bonds or foreign currency deposits cannot be considered as investments with a zero risk rate.
Real vs Nominal Risk-Free Rate
The nominal risk-free interest rate does not consider inflation. It is the stated interest on a loan or return on an investment without considering macroeconomic impacts or compounding of interest.
The real risk-free rate is adjusted for the effects of inflation. It reflects the real cost that the borrower withdraws when the investor invests.
The real risk-free rate should be considered while making a business decision for the profitability of a project.
Conversion between Real and Nominal Risk-Free Rate
Calculate Using Excel
Step 1: Insert the input data available from the website of the central bank of your country.
Step 2: Calculate the Real Rate using the formula.
Risk Free Rate of Return Formula = (1+ Government Bond Rate)/ (1+Inflation Rate)-1
Step 3: Calculate Nominal Risk-Free Rate.
The formula is: Nominal Risk Free Rate of Return Formula = (1+ Real Risk free rate)/ (1+Inflation Rate)
The risk-free rate is used to calculate the Capital Asset Pricing Model and the Weighted Average Cost of Capital.
