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What is a Risk-Free Rate?

Risk-Free Rate: Meaning

The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including default risk. Default risk is the risk that an individual or company would be unable to pay its debt obligations. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a given period of time.

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 US Dollar investments, US Treasury bills are used, while a common choice for EURO investments are the German government bonds or Euribor rates. The risk-free interest rate for the Indian Rupee for Indian investors would be the yield on Indian government bonds denominated in Indian Rupee of appropriate maturity. These securities are considered to be risk-free because the likelihood of governments defaulting is extremely low and because the short maturity of the bills protect investors from interest-rate risk that is present in all fixed rate bonds (if interest rates go up soon after a bond is purchased, the investor misses out on this amount of interest, till the bond matures and the amount received on maturity can be reinvested at the new interest rate).

Though Indian government bond is a riskless security per se, a foreign investor may look at India’s sovereign risk which would represent some risk. As India’s sovereign rating is not the highest (please search the internet for sovereign ratings of India and other countries) a foreign investor may consider investing in Indian government bonds as not a risk-free investment.

A. Sulthan
Author, Assistant Professor in Finance, Researcher and Arsenal Football Club Fan

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