What is the Risk-Free Rate and How It Impacts Your Investments?

Get a clear picture of how the risk-free rate keeps your investments safe and sound.

Let’s imagine a story to help understand the risk-free rate.

The Tale of Rani and Her Investment Choices

Rani, a young woman living in a small town in India, has saved up some money over the years. She wants to invest her savings but doesn’t know where to start. So, she decides to speak with her uncle, who is experienced in managing money.

Her uncle explains that when investing, it’s important to know the minimum return she should expect. This return is known as the risk-free rate — the amount she could earn if she put her money into something completely safe, with no risk of losing it.

The Safe Investment - Government Bonds

Her uncle tells her that the government of India offers bonds, which are like loans people give to the government. When people buy these bonds, they earn interest over time. Since the government is unlikely to fail, these bonds are considered risk-free. The money earned from these bonds is the risk-free rate.

Rani wonders, "How much would I make if I bought a government bond?"

Her uncle explains that the 10-year Government of India bond is often used to measure the risk-free rate. Currently, it’s giving a return of 7%. So, if Rani buys this bond, she would earn 7% annually, with almost no risk.

Comparing with Other Investments

Rani, feeling a little adventurous, considers investing in stocks too. Her uncle explains that stocks can be risky because the value can go up or down, unlike the steady return from government bonds. Therefore, if she wants to invest in stocks, she should expect a return higher than 7% to compensate for the risk.

For instance, if a stock offers a 10% return, Rani is taking on extra risk compared to the safe 7% from the government bond. So, the difference between the two returns (10% - 7%) helps her understand the risk she is accepting.

The Inflation Factor

Her uncle also warns her about inflation — the rise in prices over time. He tells her that if inflation is 4%, her 7% return from the government bond is actually only a 3% real return (7% - 4%), as the purchasing power of her money would have decreased due to inflation.

In the end, Rani learns that the risk-free rate is like a baseline, a starting point to judge how much return she should expect for her investments. She decides to keep some of her money in the government bonds to earn a steady return, while also taking some risks in stocks for the chance of higher profits.

Conclusion

Through Rani’s story, we understand that the risk-free rate is the return from safe investments like government bonds or treasury bills. It helps investors like Rani decide whether the return from other, riskier investments is worth the risk they’re taking.