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Risk-free interest
rate
A
risk-free interest rate is an interest rate that is obtained by investing
in financial instruments that have no risk of default. Despite the
"risk-free" assumption, financial instruments can carry risk in other
forms, such as market risk and liquidity risk. For example, the
changes in market interest rates can affect the interest rate of the
financial instrument.
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Risk-free
interest rate
Yield
Curve
In theory, risk-free assets do exist. However, many financial experts point out that this is only a theory. Professionals and academics look at short-dated government bonds, such as US Treasury bills. These are considered to be risk-free because the chance of the government defaulting is so low that it is non-existent. It just isn't feasible to include the chance of a government defaulting on its obligations. One could argue that long-term bonds issued in 1904 by the German government certainly had high risk, but only in hindsight. No one could have anticipated a World War that was followed by hyperinflation.
The short maturity of the bill also protects the investor from the interest-rate risk present in fixed-rate bonds. For example, if the interest rates go up after you purchase the bill, the investor could miss out on a small amount of interest before the bill matures. The short-term investment limits the amount of interest lost before the funds can be reinvested at the higher interest rate.
Because there is no risk, the interest rate is often lower. If any additional risk is taken on by the investor, it is rewarded with a higher interest rate or preferential tax treatment.
The risk-free interest rate is an important assumption used
in rational pricing and in the modern portfolio theory. It is required in
many financial calculations, including the Black-Scholes formula for the
pricing of stock options.