Some problems in determining the free risk rate of return

Abstract

One of the key factors in investment analysis is the risk free rate of return. The interest rate on a government bond is considered a risk free rate of return, but the bond should be free from the risk of non- payment and reinvestment risk. However, the practical determination of the risk free rate can often be followed by a number of difficulties. Therefore, in this paper we discuss the difficulties faced by an analyst in determining the risk free rate of return on investment and portfolio analysis such as: - Lack of long-term government bonds on the capital market - Exposure to the risk of government default - Change the risk free rate of return over time. I. INTRODUCTION The numerous model od assessment of risk and rate of return start with a financial asset that is defined as the risk-free asset and therefore the expected return of that asset is used as a risk-free rate of return. Then, the expected returns of risky investments are determined in relation to the risk free rate, by adding expected risk premium. To understand what makes an asset as a risk free asset, it is necessary to consider the way of the risk is measured in investment decisions. Investors who buy assets (financial or real) expect to achieve a yield in the period in which they plan to hold the asset. Realized yields that investors will achieve in a given period may vary and differ from expected returns as a result of the risk that carries the appropriate investment. To some an investment to be characterized as risk-free it needs the realized yields always to be equal to the expected yield. Such investment is risk free because the realized returns do not vary around the expected yield, i.e. the standard deviation of realized yields in terms of the expected return is equal to zero. (1)