This article needs additional citations for verification. The risk-free interest rate is the rate of return of a hypothetical investment with no risk of financial social discount rate investopedia forex, over a given period of time.
Since the risk-free rate can be obtained with no risk, any other investment having some risk will have to have a higher rate of return in order to induce any investors to hold it. In practice, to infer the risk-free interest rate in a particular situation, a risk-free bond is usually chosen—that is, one issued by a government or agency whose risks of default are so low as to be negligible. As stated by Malcolm Kemp in Chapter five of his book Market Consistency: Model Calibration in Imperfect Markets, the risk-free rate means different things to different people and there is no consensus on how to go about a direct measurement of it. Expected increases in the money supply should result in investors preferring current consumption to future income. Expected increases in productivity should result in investors preferring future income to current consumption. Tobin makes on page 17 of his book Money, Credit and Capital.
However, it is commonly observed that for people applying this interpretation, the value of supplying currency is normally perceived as being positive. Adam Smith in The Wealth of Nations. Again, there are reasons to believe that in this situation the risk-free rate may not be directly observable. Given the theoretical ‘fog’ around this issue, in practice most industry practitioners rely on some form of proxy for the risk-free rate, or use other forms of benchmark rate which are presupposed to incorporate the risk-free rate plus some risk of default. However, there are also issues with this approach, which are discussed in the next section. The return on domestically held short-dated government bonds is normally perceived as a good proxy for the risk-free rate. In business valuation the long-term yield on the US Treasury coupon bonds is generally accepted as the risk-free rate of return.
However, theoretically this is only correct if there is no perceived risk of default associated with the bond. There is also the risk of the government ‘printing more money’ to meet the obligation, thus paying back in lesser valued currency. This may be perceived as a form of tax, rather than a form of default, a concept similar to that of seigniorage. But the result to the investor is the same, loss of value according to his measurement, so focusing strictly on default does not include all risk. The same consideration does not necessarily apply to a foreign holder of a government bond, since a foreign holder also requires compensation for potential foreign exchange movements in addition to the compensation required by a domestic holder. Since the risk-free rate should theoretically exclude any risk, default or otherwise, this implies that the yields on foreign owned government debt cannot be used as the basis for calculating the risk-free rate.
Since the required return on government bonds for domestic and foreign holders cannot be distinguished in an international market for government debt, this may mean that yields on government debt are not a good proxy for the risk-free rate. Another possibility used to estimate the risk-free rate is the inter-bank lending rate. This appears to be premised on the basis that these institutions benefit from an implicit guarantee, underpinned by the role of the monetary authorities as ‘the lendor of last resort. Similar conclusions can be drawn from other potential benchmark rates, including AAA rated corporate bonds of institutions deemed ‘too big to fail. There are some assets in existence which might replicate some of the hypothetical properties of this asset. The risk-free interest rate is highly significant in the context of the general application of modern portfolio theory which is based on the capital asset pricing model.
Scholes formula for pricing stock options and the Sharpe ratio. The risk-free rate of return is the key input into cost of capital calculations such as those performed using the Capital Asset Pricing Model. The cost of capital at risk then is the sum of the risk-free rate of return and certain risk premia. This page was last edited on 10 May 2018, at 03:44.
This article is about investment in finance. This article needs additional citations for verification. In finance, the benefit from investment is called a return. The return may consist of capital gains or investment income, including dividends, interest, rental income etc. Investors generally expect higher returns from riskier investments. Investors, particularly novices, are often advised to adopt a particular investment strategy and diversify their portfolio. Diversification has the statistical effect of reducing overall risk.