Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. One interpretation is that the risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time. Another interpretation is that the risk free rate is the compensation that would be demanded by a representative investor holding a representative market portfolio, comprising all the assets in the economy, (i.e. the risk free rate is the compensation for systemic risk which cannot be eliminated by holding a diversified portfolio.) It is the second interpretation which is applied in the Capital Asset Pricing Model. (Refer to The Econometrics of Financial Markets, by Campbell, Lo and MacKinlay.)
Since the risk free rate can be obtained with no risk, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate.
Read more about Risk-free Interest Rate: Theoretical Measurement of The Risk Free Rate, Proxies For The Risk-free Rate, Application
Famous quotes containing the words interest and/or rate:
“History in the making is a very uncertain thing. It might be better to wait till the South American republic has got through with its twenty-fifth revolution before reading much about it. When it is over, some one whose business it is, will be sure to give you in a digested form all that it concerns you to know, and save you trouble, confusion, and time. If you will follow this plan, you will be surprised to find how new and fresh your interest in what you read will become.”
—Anna C. Brackett (1836–1911)
“All of us failed to match our dreams of perfection. So I rate us on the basis of our splendid failure to do the impossible.”
—William Faulkner (1897–1962)