This video covers one of the most fundamental concepts in Finance… the Risk Free Rate.
VIDEO SUMMARY
The risk free rate is a really important concept in finance. So I’m going to spend some time talking about it because it is not entirely intuitive. What the risk free rate means is, it is finance professionals looking at all the potential investment opportunities around the world, and out of all of these opportunities, they find the one opportunity that is the most risk free. That becomes the risk free rate. So it is not entirely without risk. Everything always has risk. We are talking about investments. We are talking about the future. There is always some level of uncertainty. But what the risk free rate stands for is what is the most risk free opportunity out there and what is the return that you are expecting from that. What happens is that rate sets your benchmark. In finance we are always talking about risk and return. The higher the risk the more return you should expect. You are starting from this benchmark of the risk free rate. It becomes this spectrum and the higher the risk that you take on, the more return you should expect.
So let’s talk about how this is used on a practical level because what happens is people use US treasuries as the risk free rate. So let’s talk about why they do that. The US economy is somewhat unique around the world. It is very massive, and it’s been very consistent over a long period of time. There is not risk of political uprising. It has a strong legal system. And so when you compare the US against other countries around the world, the US stands as the least risky alternative. Now this could change in the future, but for right now, and for the near-term the US is the least risky alternative. At least that is what most people use. So when you are looking at the US, the reason why government bonds are considered less risky than company stock for instance, is companies can go bankrupt. Governments generally don’t go bankrupt. The reason why is a company could have an accounting scandal and the next day it goes bankrupt. You lose all your money. That doesn’t generally happen with government. A government is represented by the economic activity of its people. So in the case of America, the American people generate economic activity. They have done consistently over a very long period of time, and a portion of that economic activity goes to paying taxes. Those taxes become part of the government budget, and part of that government budget goes to paying interest payments to people who hold US treasuries. So it all flows back to the American people. They are really the ones who are responsible for paying these IOUs to the government because if the government ever gets into trouble with where they can’t pay an interest payment, they can always just raise taxes and get the money that way. Now you can’t raise taxes forever, but in general, when you are investing in a government security you are really investing in the economic potential of the people of that nation. So comparing countries around the world, the US is a very low risk place to invest. Now I am not hyping US investments, that is not what I’m doing. You can invest in all kinds of opportunities. I’m just talking about the risk free rate here. And the risk free rate, because it is low risk, will also be low return. You are going to get a low return from buying US treasuries, but that is not the point here. Whatever you are deciding to invest in, whether it is corporate bonds, corporate stocks, or emerging markets, you are going to be getting a higher return. But it is all comparative. You are comparing it to your benchmark, which is the risk free rate, which is the least risky investment opportunity.
So the point that I want to get across here, is how interrelated everything in finance is, because no matter what it is that you are investing in, everybody is watching this risk free rate. Because the US treasury is just like everything else in finance. It is a market and it moves up and down. As the US treasury is moving up and down, that is impacting everything else in finance. Everything else in finance is built on top of that risk free rate. I don’t think a lot of people appreciate how important the US Treasury is. It is important because of this risk free rate concept.
So let’s just talk through an example to help you understand this. If you are making an investment decision, and I am just going to use hypothetical numbers here. Let’s say you are looking at an investment opportunity at a certain snapshot in time. You are looking at the US stock market. It is returning an eight percent risk premium over the risk free rate. The risk free rate at the time is four percent. So adding the two together equals twelve percent for that stock market investment. You should be expecting the return of twelve percent. Now again, this is built on the risk free rate which changes over time. So you are looking at your investments with all these changing factors, but you are making decisions based on comparing it against the risk free rate. The other thing to consider is if you are looking at an investment opportunity and the return you are going to get is lower than the risk free rate, it is lower than what you get for a US treasury. Then that is not a very good investment. You are better off just investing in US treasuries because the risk return is not appropriate. So to recap, we talked about the risk free rate, we gave a definition for what that is, and we also explained why on a practical level people use the US treasury as the risk free rate.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.