Definition of Risk-Free Interest Rate
Risk-free interest rate is defined as the theoretical interest rate on certain investment with no associated risk of financial loss. Risk-free interest rate is the rate that an investor expects to get on the risk investment over a specific period. In other words, Risk-free interest rate can be delineated as the amount of compensation which is claimed by representative investor with the representative market portfolio, comprising all assets in the economy. This explanation is usually implied by in the capital asset pricing model.
Though the risk-free rate can be attained by with no risk taken; as a result, the investor should be awarded an extra interest if additional risk is taken by investor, and it should be higher than the risk-free rate. In finance the most risk and return model associated with asset can be defined as a risk-free and the expected return on the investments is called risk-free interest rate.
Books on Risk-Free Interest rate
Entrepreneurial Finance By J. Leach, Ronald Melicher (published by Cengage Learning, 2014)
Fundamentals of Financial Management By Eugene Brigham, Joel Houston (published by Cengage Learning, 2009)
How Risk-free Interest Rate works?
Here with a few examples the idea of Risk-free interest is described,
- In practical life, Risk-free interest does not exist in that, because every small investment carries a small amount of risk at its maturity, there is no investment policy than 100% assurance on the return rate, only three-month U.S. Treasury bill is considered as risk-free interest rate, the interest rate of U.S. Treasury bill can be assured.
- Suppose an investor has lent its money to a one-year Treasury bill (or any other default-free one-year bond) with one year time, he has expected 5 % return in the investment, at the time of maturation the investor would always gain 5% return on his investment which he has expected before investments.
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