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Definition: Risk Free Rate
Risk-free rate (RFR, often symbolised as ‘Rf’) is theoretically the rate of return with zero risk. For any rational investor, a promise of higher return can only indulge him to take a higher risk. Thus, since risk-free rate is the minimum assured return without any risk at all, it is the minimum level of return existing in a market. No rational investor will be ready to accept sub-risk-free of return.
However, in reality, there exists no such security or financial instrument which is devoid of any risk. As a benchmark, for USD transactions, 90-day U.S. treasury bills are assumed to yield risk-free rate of return. Since these T-bills are backed by the full faith of the U.S. government, very small risk is associated with it. For example, default risk will be very low. As the duration of these securities is very small, interest-rate risk and reinvestment risks are also low compared to other longer fixed-income securities. Quite similarly, for EUR transactions, German government bills are assumed to be risk-free.
In many countries, the government has the right to print currencies to fulfil its debt. So even in case the government exhausts its debt-paying capacity, it assures payment to its investors through this last resort. So government securities carry such low risk.
Application: The risk-free rate is an important parameter in various areas of finance viz. CAPM (Capital asset pricing model) for stock returns, BSM (Black-Scholes-Merton) pricing model for options, Sharpe Ratio in portfolio investment theory, etc.