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 come with zero risks.
Basically, the
risk-free rate is commonly considered to be equal to the interest paid on a 3-month
government Treasury bill, generally the safest investment an investor can make.
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.
It can be concluded
that a Risk-free rate of return is a hypothetical rate of interest that an
investor would expect from an investment without incurring any risk. That means
the investor is assured to get the principal amount and a minimal return over a
specified period of time.
Risk
premium represents the extra return above the
risk-free rate that an investor needs in order to be compensated for the risk
of a certain investment. In other words, the riskier the investment, the higher
the return the investor needs.
The risk premium is measured
as the total expected return minus the return on a risk-free asset, such as a
treasury bill issued by the government or central Bank. For more, here input
pictorial presentation of the Risk Premium formula.
Asset Return -
Risk-Free Rate = Risk Premium