Risk-free rate

Definition

The risk-free rate is the theoretical return on an investment with zero risk of financial loss. It typically represents the interest rate on short-term government securities, like U.S. Treasury bills, considered free from default risk.

5 Must Know Facts For Your Next Test

1. The risk-free rate is a key component in the Capital Asset Pricing Model (CAPM) used to calculate the expected return of an asset.
2. It serves as a benchmark for evaluating the attractiveness of other investments.
3. In practice, the yield on short-term government securities, such as Treasury bills, is often used as a proxy for the risk-free rate.
4. The risk-free rate helps in determining the cost of capital and discount rates in various financial models.
5. Inflation can affect the real value of returns even if nominal returns are guaranteed.

Review Questions

• Why is the risk-free rate considered to have zero risk?
• How does the risk-free rate factor into the Capital Asset Pricing Model (CAPM)?
• What is commonly used as a proxy for the risk-free rate in financial calculations?

Related terms

CAPM: The Capital Asset Pricing Model estimates an investment's expected return based on its systematic risk.

Treasury Bill: A short-term government security with a maturity of less than one year, commonly used as a proxy for the risk-free rate.

Cost of Capital: The required return necessary to make a capital budgeting project worthwhile.