The risk free interest rate is a theoretical term that is obtained by making investments in those financial securities that are exposed to no default risk. But the financial instruments can be with other types of risks like liquidity risk, market risk and many more. According to some economic and finance theory, it is assumed that the market participants can borrow at risk free rate but in practical world, very few borrowers have access to the finance at risk free interest rate.
The concept of risk free assets exists only in theory. But the government bonds of the currency that are short-dated are the assets, which are considered to be risk free interest assets by most of the academics and professionals.
These securities are considered risk-free securities because there is very little chance that the governments will default on these bonds. The fact that these securities are short term in nature also ensures the investors against interest-rate risk, which is otherwise present in the fixed rate bonds.
But there are possibilities that the investors will miss some amount of interest if the interest rates go up just after the bill is purchased. In cases of the short term securities the investors can reinvest at the new interest rate.
Since in the cases of risk free interest rates, the interest rate can be gained with no risk, it can be said that any other risk taken by an investor should be rewarded with an interest rate that is higher than the risk-free rate.
The application of risk free interest rate has various aspects. To the modern portfolio theory, the risk free interest rate is of high importance. The concept of risk free interest rate gives an important assumption for rational pricing. The theory also makes needful input in the financial calculation theories like Black-Scholes formula for stock pricing options.
Last Updated on : 1st July 2013