Risk-Free Rate

The risk-free rate is the nominal interest rate we would receive for an instrument with absolutely zero credit risk and zero inflation risk. In practice credit and inflation risk are never exactly zero, but over the short run AAA government securities are extremely close to being risk free. In the US, 90 day Treasury rates are often used as a proxy for the risk-free rate. For a given maturity, the risk-free rate should be the lowest interest rate available.

The risk-free rate enters into a number of security pricing formulas. Because of this, and because of various arbitrage conditions, rather than using the lowest interest rate available, market participants will often use the lowest interest rate readily available to them. 90-day Libor is often used as a proxy for the risk-free rate in practice.


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