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The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

It’s a theoretical concept, because in reality, no investment is entirely without risk. When you buy stock or other investments, there is always a chance that you will lose money.

Theoretically, even the United States government has a chance of defaulting on its bonds, but because that is very unlikely, the risk-free rate is usually based on the current interest rate of a three-month U.S. Treasury bill, since it is just about the safest investment you can make.

Why is the risk-free rate important?  It is important to economists and financial institutions because they use it as the starting point for calculating the cost of equity and capital.  For instance, a bank considering a loan application will start with the risk-free rate and then add additional interest for other risk components such as default risk, inflation risk, and, if the loan is to a foreign company, currency risk.

 

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