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What is a Risk Free Rate?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 01 November 2016
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    Conjecture Corporation
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A risk free rate is a rate of interest that applies to a financial instrument that is considered to be without risk of default. While no financial instrument truly exists that does not carry some degree of risk, assets such as government issued securities are generally deemed to have such a small amount of risk that they meet the standard for classification as risk free. All interest earned during the time in which the investor holds the financial instrument is calculated as a risk free rate of interest. Depending on the terms related to the asset, the risk free rate may be in the form of a fixed rate or a variable rate of interest.

It is important to remember that while assets that carry a risk free rate are practically free from the possibility of default, other types of risk factors may still apply. For instance, changes in the interest rates that apply in the marketplace may have some degree on the asset. In like manner, any factor that would make it impossible to sell the asset for cash in a relatively short period of time would increase the degree of liquidity risk associated with the holding.

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The main benefit of a financial instrument that comes with a risk free rate of interest is that the possibility of the issuer defaulting is so low that some highly unlikely chain of events must take place before a default situation would be triggered. For people who look for the safest investments possible, a government-issued bond would be an excellent choice. In decades past, a number of national governments issued these types of bonds, allowing even people with limited incomes to purchase a bond now and then, hold it for a number of years, then redeem the bond for the original payment plus the accrued interest.

While the default risk of the financial instrument that earns a risk free rate is practically non-existent, an investment of this type may not be the best option for some investors. Since there is so little risk involved, the risk free interest rate is likely to be lower than the interest earned on bond issues and other relatively safe investments. For this reason, it is important for the investor to look closely at not only the amount of interest that is earned over the life of the holding, but also how long it will take for the holding to mature. If the duration until maturity is longer than the investor fees is equitable for the level of return, he or she would do well to focus on other investment opportunities that involve slightly more risk, but also provide a higher return.

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