Risk-free interest rate

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.

Since the risk free rate can be obtained with no risk, any other investment will have additional risk.

In practice to work out the risk-free interest rate in a particular situation, a risk-free bond is usually chosen that is issued by a government or agency where the risks of default are so low as to be negligible.

Risk components

Risks that may be included are default risk, currency risk, and inflation risk.

Theoretical measurement

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.

One interpretation of the theoretical risk-free rate is aligned to Irving Fisher's concept of inflationary expectations, described in his treatise The Theory of Interest (1930), which is based on the theoretical costs and benefits of holding currency. In Fisher’s model, these are described by two potentially offsetting movements: