What is Risk-free rate?

The risk-free rate is the return an investor can earn without taking any real chance of losing money. Nothing is completely free of risk, so investors use a stand-in: the interest on short-term government debt. The most common choice is three-month US Treasury bills (T-bills, which are loans to the US government repaid within a year). A government borrowing in its own currency for a few months is very unlikely to miss a payment. The rate works as a baseline: any risky investment, such as shares, is judged by how much it earns above it.

Say the T-bill rate is 4% a year and you invest $10,000 in a stock portfolio that returns 10% over the year, ending at $11,000. Had the money sat in T-bills instead, it would have grown to $10,400. The extra $600, or 6 percentage points, is the excess return, which is the reward for accepting risk. The same number feeds the Sharpe ratio, a measure created by William F. Sharpe. It divides excess return by volatility, which is how much returns swing around their average. If the portfolio's volatility is 15%, the Sharpe ratio is 6 ÷ 15 = 0.4. With a risk-free rate of 1% instead, the excess return would be 9% and the Sharpe ratio 0.6, which shows how much the choice of rate matters.

The name overstates things. T-bills protect against default and large price swings, but not against inflation, the general rise in prices. If T-bills pay 4% while prices rise 3%, the real return (the gain in purchasing power) is only about 1%, and it can turn negative. The rate also changes as central banks raise and lower interest rates, so a figure from one period says little about another. A common misunderstanding is to treat longer government bonds as risk-free as well. They are safe from default, but their prices fall when interest rates rise. In 2022, US inflation reached about 9% and long-term Treasuries lost about 30%.

For a private investor building a long-term portfolio, the risk-free rate is the honest comparison point. Cash in T-bills or a similar account is always available, so a risky holding earns its place only if it offers a reasonable chance of doing better after allowing for its ups and downs. The rate also helps put performance figures in context. A hypothetical backtest showing 6% a year looks quite different when cash paid 1% than when it paid 5%. Keeping the risk-free rate in mind turns raw returns into a clearer picture of what risk actually paid.

By Dr. Harry Hamann

What is the risk-free rate today?
It changes constantly as interest rates move. Investors usually look up the current yield on three-month US Treasury bills, published daily by the US Treasury and shown on most financial data sites.

Is the 10-year Treasury yield the risk-free rate?
Some analysts use it for long-term valuations, but its price swings when interest rates change. For measuring short-term risk and the Sharpe ratio, the three-month T-bill rate is the more common choice.

Why is the risk-free rate used in the Sharpe ratio?
The Sharpe ratio measures the reward for taking risk. Subtracting the risk-free rate removes the part of the return that cash would have earned anyway, leaving only the extra return gained by accepting volatility.

Can the risk-free rate be negative?
Yes. Some governments have paid below-zero rates on short-term debt. Even with a positive rate, the real return after inflation turns negative whenever prices rise faster than the T-bill rate.