Real Risk-Free Rate Calculator
Calculate the Real Risk-Free Rate using the Fisher Equation based on Nominal yields and Inflation.
* The Exact rate uses the Fisher Equation. The Approximate rate is simply Nominal minus Inflation.
Understanding the Risk-Free Rate (RFR)
The Risk-Free Rate (RFR) is a foundational concept in modern finance, representing the theoretical return of an investment with zero risk of financial loss. It serves as the baseline from which all other risky assets are measured. Investors demand a premium over this rate to accept additional risk.
In practice, since no investment is truly free of all risk, the yields on sovereign government bonds (like U.S. Treasury Bills or Bonds) are used as the primary proxy for the nominal risk-free rate, assuming the government will not default on its debt obligations.
Nominal vs. Real Risk-Free Rate
When you look up the yield on a 10-year Treasury note, you are seeing the Nominal Risk-Free Rate. This rate includes compensation for expected inflation. However, for long-term planning and valuation models, investors are often interested in the Real Risk-Free Rate, which represents the purchasing power growth of the investment.
- Nominal RFR: The stated interest rate on a risk-free bond.
- Real RFR: The nominal rate adjusted for inflation.
The Fisher Equation
To convert the nominal rate to the real rate, this calculator utilizes the Fisher Equation. While many use a simple subtraction (Nominal – Inflation), the precise geometric formula provides better accuracy, especially during periods of high inflation.
Solving for Real Rate:
Real Rate = [(1 + Nominal Rate) / (1 + Inflation Rate)] – 1
Why is the RFR Important?
The Risk-Free Rate is a critical input in various financial models:
- CAPM (Capital Asset Pricing Model): Used to calculate the cost of equity (Ke = RFR + Beta × Equity Risk Premium).
- Sharpe Ratio: Used to calculate risk-adjusted return ((Portfolio Return – RFR) / Standard Deviation).
- Option Pricing: The Black-Scholes model requires the RFR to discount the exercise price.
- DCF Valuation: Used as a component of the Weighted Average Cost of Capital (WACC) for discounting future cash flows.
How to Find the Input Values
To use this calculator effectively, you need current market data:
- Nominal Rate: Look up the yield for a U.S. Treasury bond that matches your investment horizon (e.g., 3-month T-Bill for short term, 10-year T-Note for long term).
- Inflation Rate: Use the expected inflation rate (breakeven inflation rate) implied by the difference between nominal Treasury yields and Treasury Inflation-Protected Securities (TIPS), or use recent CPI forecasts.