Risk-Free Interest Rate

The risk-free interest rate is the return on an investment that is considered to carry no risk of default. It is typically represented by the yield on government bonds issued by stable countries, such as U.S. Treasury bonds. The risk-free rate is an essential concept in finance because it serves as a baseline for determining the required return on riskier investments. Investors use the risk-free rate as a benchmark to assess the opportunity cost of holding risk-free assets versus riskier alternatives.

Example

If the yield on a 10-year U.S. Treasury bond is 2%, this is considered the risk-free interest rate, as it carries virtually no risk of default.

Key points

• The return on an investment with no risk of default, typically represented by government bonds.

• Used as a benchmark for evaluating the required return on riskier investments.

• Serves as the foundation for models like the Capital Asset Pricing Model (CAPM).

Quick Answers to Curious Questions

Why is the risk-free interest rate important in financial models?

It provides a baseline for calculating the required return on riskier investments, helping investors determine risk premiums.

What factors influence the risk-free interest rate?

Economic conditions, government borrowing, and central bank policies can influence the risk-free rate by affecting the supply and demand for government bonds.