A risk-free rate is an interest rate applied to a financial instrument considered to have no risk of default, such as government-issued securities, but other types of risk factors may still apply. While it is virtually free from the possibility of default, the risk-free interest rate may not be the best option for some investors as it is likely to be lower than the interest earned on bond issues and other relatively safe investments.
A risk-free rate is an interest rate that is applied to a financial instrument that is considered to be without risk of default. While there is really no financial instrument that does not carry some degree of risk, assets such as government-issued securities are generally considered to have such a small amount of risk that they meet the standard for classification as risk-free. All interest earned during the time the investor owns the financial instrument is calculated as a risk-free interest rate. Depending on the terms associated with the asset, the risk-free rate can be in the form of a fixed rate or a variable interest rate.
It is important to remember that while assets that have a risk-free rate are virtually free from the possibility of default, other types of risk factors may still apply. For example, changes in interest rates that apply in the market may have some degree on the asset. Similarly, any factor that makes it impossible to sell the asset for cash in a relatively short period of time would increase the degree of liquidity risk associated with the holding.
The main benefit of a financial instrument that comes with a risk-free interest rate is that the possibility of issuer default is so low that a highly improbable chain of events must occur before a default event is triggered. For people looking for the safest investments possible, a government-issued bond would be a great option. In decades past, various national governments have issued this type of bond, allowing even people with limited incomes to purchase a bond from time to time, hold it for several years, and then redeem the bond for the original payment plus accrued interest.
While the risk of default for a financial instrument earning a risk-free rate is virtually non-existent, such an investment may not be the best option for some investors. Since there is very little risk involved, the risk-free interest rate is likely to be lower than the interest earned on bond issues and other relatively safe investments. For this reason, it is important for the investor to take a close look at not only the amount of interest that is earned over the life of the tenure, but also how long it will take for the tenure to mature. If the duration to maturity is greater than the investor’s fees are fair for the level of return, he or she would do well to focus on other investment opportunities that carry a little more risk, but also provide higher returns.
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