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Monday, February 06, 2006

Risk-free-interest-rate



The risk-free interest rate is the interest rate that it is assumed can be obtained by investment in financial instruments with no risk. Though a truly risk-free asset exists only in theory, in practice most professionals and academics use short-dated government bond (finance)s of the currency in question. For USD investments, usually Government of the United States treasury bills are used, whilst a common choice for EUR investments are German government treasury bonds. Those securities are considered to be risk-free because the likelihood of the government default (finance) is extremely low, and because the short maturity of the bill protects the investor from interest-rate risk that is present in all fixed-rate bonds. Since this interest 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. The risk-free interest rate is thus of significant importance to Modern portfolio theory in general, and is an important assumption for Rational pricing. It is also a required input in financial calculations, such as the Black-Scholes formula for pricing stock options.