Risk-free interest rate

Risk-free interest rate

The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk. However, the financial instrument can carry other types of risk, e.g. market risk (the risk of changes in market interest rates), liquidity risk (the risk of being unable to sell the instrument for cash at short notice without significant costs) etc.

Risk-free assets

Though a truly risk-free asset exists only in theory, in practice most professionals and academics use short-dated government bonds of the currency in question. For USD investments, usually US Treasury bills are used, while a common choice for EUR investments are German government bills or Euribor rates. The mean real interest rate of US treasury bills during the 20th century was 0.9% p.a. (Corresponding figures for Germany are inapplicable due to hyperinflation during the 1920s.) [Dimson, Marsh & Staunton: "Triumph of the Optimists", Princeton Universtity Press, 2002.]

These securities are considered to be risk-free because the likelihood of these governments defaulting is extremely low, and because the short maturity of the bill protects the investor from interest-rate risk that is present in all fixed rate bonds (if interest rates go up soon after the bill is purchased, the investor will miss out on a fairly small amount of interest before the bill matures and can be reinvested at the new interest rate).

Since this interest rate can be obtained with no risk, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate (on an after-tax basis, which may be achieved with preferential tax treatment; some local government US bonds give below the risk-free rate).

Application

The risk-free interest rate is thus of significant importance to Modern Portfolio Theory in general, and is an important assumption for rational pricing. It is also a required input in financial calculations, such as the Black-Scholes formula for pricing stock options. Note that some finance and economic theory assumes that market participants can borrow at the risk free rate; in practice, of course, very few borrowers have access to finance at the risk free rate.

Why risk-free?

One explanation for the assumption that no default risk exists is due to the nature of government debt. For a fiat currency, the government retains the theoretical capacity to print as much of that currency as will be required to pay its own debts (in that currency). In this case, true default is theoretically impossible: owners of government debt can always be paid, but with money that may have substantially lower value. Rather than reflecting the default risk of the government, the risk-free interest rate, therefore, reflects the likelihood that the government will print money to pay its debts, thereby debasing the currency. Note that this does not apply to currencies such as the Euro where no individual government has the authority to print currency. Of course, many countries have other measures and institutions (such as theoretically independent central banks) to reduce the likelihood of such an occurrence.

An alternative interpretation is that, while no investment is truly free of risk, scenarios in which a major government with a long track record of stability defaults on its obligations are so far outside what is known that one cannot make quantitative statements about their chances of happening, and therefore it is simply not feasible to include them in financial planning. A German investor living circa 1904 trying to decide whether to purchase long-term bonds issued by the German government could scarcely have been able to anticipate a World War followed by hyperinflation.

References

ee also

*Short rate model
*Real interest rate
*Capital asset pricing model
*Beta coefficient


Wikimedia Foundation. 2010.

Игры ⚽ Поможем сделать НИР

Look at other dictionaries:

  • risk-free interest rate — Describes return available to an investor in a security somehow guaranteed to produce that return. The risk free interest rate compensate s the investor for the temporary sacrifice of consumption. Bloomberg Financial Dictionary …   Financial and business terms

  • risk free rate — interest rate for a property that has certain profit …   English contemporary dictionary

  • Interest rate — Finance Financial markets Bond market …   Wikipedia

  • Interest rate swap — An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party s stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They… …   Wikipedia

  • Risk-Free Rate Of Return — The theoretical rate of return of an investment with zero risk. The risk free rate represents the interest an investor would expect from an absolutely risk free investment over a specified period of time. In theory, the risk free rate is the… …   Investment dictionary

  • Risk-Free Return — The theoretical rate of return attributed to an investment with zero risk. The risk free rate represents the interest on an investor s money that he or she would expect from an absolutely risk free investment over a specified period of time. In… …   Investment dictionary

  • Interest Rate Parity — A theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting …   Investment dictionary

  • Risk-Free Asset — An asset which has a certain future return. Treasuries (especially T bills) are considered to be risk free because they are backed by the U.S. government. Because they are so safe, the return on risk free assets is very close to the current… …   Investment dictionary

  • risk-free return —  The interest rate on the lowest risk investment, usually a U.S. government security, for that period of time.  ► Investors compare the yield premium over the risk free return versus the risk of the investment …   American business jargon

  • Interest — For other uses, see Interest (disambiguation). Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money,[1] or money earned… …   Wikipedia

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”