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Investors need to be aware of every term and phrase when it comes to the share market. Staying updated with the current trends and deciding to invest in different types of investment options is a great practice.

While several investors know many terms and their meaning, there’s one term that most investors have often heard of but don’t have an exact idea about what this term means and that the term is a risk-free rate of return.

If an investor stepping into the investing field hasn’t heard or understood it entirely, there might be several possible questions going around in their head. Some questions like:

1) What does the risk-free rate of return mean?

2) Does it really exist in the investing field?

3) What investments is the risk-free return applicable to?

To understand the entire concept of the risk-free rate of return, it’s best to get started and learn the basic fundamental question: What is the risk-free rate of return? So let’s get started.

All investments have some degree of risk which means that it may not be practically possible for an investor to get a risk-free rate of returns while making an investment.

However, this term is used to refer to the returns obtained from specific investment options, such as the US treasury bonds or the German government bonds.

The primary reason behind this is that developed countries like Germany and the USA have the risk associated with government-backed bonds, which is negligible enough for the earnings to be considered risk-free returns.

The risk-free returns typically reflect three significant components, namely:

**Inflation****The Rental Rate****The Investment Risk**

**So let’s understand all three components in detail:**

**Inflation**

Inflation means that there is a sudden increase in the price of goods and services with time. In simple words, it’s the decrease in purchasing power across a given period.

However, inflation is considered for the tenure of the investment option in question.

**The Rental Rate**

This term refers to the rate of the actual or the real returns associated with lending the funds over the investment period.

**The Investment Risk**

Investment risk is also called maturity risk, which means the risk associated with the principal market value of the investment.

The risk can either increase or decrease during the investment tenure due to the change in the level of interest rates prevailing in the economy.

Till now, investors should have understood the meaning of risk-free rate of return, but as an investor, there can be several other questions like how this rate affects the investor? And that’s a strong question to consider. So let’s understand what the risk-free rate of return means to investors.

The risk-free rate of returns are generally associated with investments that carry zero levels of risk. It simply means that any other investment option that carries more than zero risks must offer returns at a higher rate to attract investors.

The risk-free rates act as a basis for calculating other rates, such as the cost of equity, which is calculated by adding a risk premium to the rate of risk-free returns prevailing in the market.

This risk premium accounts for the additional element of risk associated with other investment options. However, the risk-free interest rate can also be used to calculate the cost of debt.

Here, a default spread is added to the risk-free rate to account for the increased risk. This spread depends on the level of credit risk associated with the issuer of the debt instrument.

**Conclusion**

Now that an investor is fully understood about what the risk-free rate of return is, they can consider this metric before stepping and making any investment decisions.

One thing that every investor should keep in mind is that the risk-free rate is not a constant number and keeps changing depending upon various microeconomic and macroeconomic factors.

So an investor should stay updated about the current risk-free rate swirling around the market.

**What is the Risk-Free Rate of Return?****What does investment risk means?****How many components reflect the risk-free return rate?**

The risk-free rate of return is the least rate of return earned by an investor from an investor who holds zero risks. This is a theoretical concept made by some experts because, in practice, there’s no such investment that does not comes with zero risks.

Investment risk is also called maturity risk, which means the risk associated with the principal market value of the investment.

The risk can either increase or decrease during the investment tenure due to the change in the level of interest rates prevailing in the economy.

The risk-free returns typically reflect three significant components, namely:

1) Inflation

2) The Rental Rate and

3) The Investment Risk