Riskless Rate of Return
Meaning and definition of riskless rate of return
Risk free rate of return refers to the theoretical rate of return of an investment involving zero risk. The riskless rate represents the interest expected by an investor from a completely riskless investment over a certain time period. As explained by Investopedia, in theory, the riskless rate implies the minimum return which is expected to be received by an investor for an investment for he/she will not accept extra risk unless the possible rate of return is higher than the riskless rate.
However, practically, the riskless rate of return does not subsist as even the safest investments contain a very small amount of risk.
How risk free is the riskless rate of return?
The riskless rate of return is considered as one of the most basic elements of modern finance and many of its most known theories, the capital asset pricing model (CAPM), Modern Portfolio Theory (MPT), and the Black-Scholes model, implement the riskless rate as the primary element from which other evaluations are derived. The riskless asset applies only in theory, but the actual safety comes rarely into question until actions fall far beyond the usual daily volatile markets. Even though it is easy to take shots at theories which involve a riskless asset as their base, there are limited options to be used as a proxy.
The risk-less rate is seldom called into question until the economic milieu falls into disorder. Catastrophic events, such as credit-market collapses, stock market collapses, war, and dramatic currency devaluations, can result in people questioning the safety and security of the US government as a lender. The best method for evaluating a riskless security would be using the standard credit evaluation techniques, like the ones which would be used by an analyst for evaluating the creditworthiness of a business entity.
Unfortunately, the metrics applied to the US government hardly ever hold up because of the fact that they subsist in perpetuity by nature and also have unlimited powers for raising short term as well as long term funds required for funding and spending.