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Concept
Risk-free rate
Summary
The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time that is assumed to meet all payment obligations.
Since the risk-free rate can be obtained with no risk, any other investment having some risk will have to have a higher rate of return in order to induce any investors to hold it.
In practice, to infer the risk-free interest rate in a particular currency, market participants often choose the yield to maturity on a risk-free bond issued by a government of the same currency whose risks of default are so low as to be negligible. For example, the rate of return on zero-coupon Treasury bonds (T-bills) is sometimes seen as the risk-free rate of return in US dollars.
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:
Expected increases in the money supply should result in investors preferring current consumption to future income.
Expected increases in productivity should result in investors preferring future income to current consumption.
The correct interpretation is that the risk-free rate could be either positive or negative and in practice the sign of the expected risk-free rate is an institutional convention – this is analogous to the argument that Tobin makes on page 17 of his book Money, Credit and Capital. In a system with endogenous money creation and where production decisions and outcomes are decentralized and potentially intractable to forecasting, this analysis provides support to the concept that the risk-free rate may not be directly observable.
Official source
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