Risk Free Rate
Why is the risk free rate important to financial calculations? The RFR (risk free rate) is a fundamental building block to many financial models as this rate represents the minimum hurdle rate of return for any other asset that contains risk. Otherwise, any "rational" investor would simply buy a US Treasury asset that is considered "risk free". Per the definition used by
risk.net, "The risk-free rate is the theoretical rate of return on an investment with zero risk. As such, it is the benchmark to measure other investments that include an element of risk."
RFR Applications in Finance
One very common uses of the RFR is found in the calculation of the popular
Sharpe Ratio - which measures the performance of an investment such as a security or portfolio compared to a risk-free asset, after adjusting for its risk. Risk free rates across all maturities can be used to discount future cashflows and serve as inputs to other discounted cash flow (DCF) models.
Par Yield Curve(s)
For the contents of this article, we will use Par Yield Curve rates as our metric for the risk free rate. Per
Investopedia, the par yield rate "is used to determine the coupon rate that a new bond with a given maturity will pay in order to sell at par today". In our code example below, we will use the nearest maturity (1 month) as the RFR. As another note, it is typical to match your risk free rate to the maturity of the underlying asset. For example, if you are want to find the risk free rate to discount a futures' contract that has a maturity 3 months from now, you will likely want to use the par yield curve rate with a 3mo maturity (rather than what we demonstrate for 1month). The data returned from the US Treasury website is for the full par yield rate curve, going all the way out to 30 years. As always, every line of code is commented/documented for you to easily understand, follow, and edit to fit your purpose.
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