Risk-free rate
The return on an investment with no default risk over the horizon, usually proxied by short-term government bills. Every risky return is measured against it, and option models discount the exercise price at it.
Where you will meet it
Risk-free rate appears in 30 learning outcomes on the CFA syllabus. A few of them:
- Estimate the return equity holders require with both the market model and the CAPM
“The capital asset pricing model estimates the required return on equity as the risk-free rate plus beta times the equity risk premium: r = Rf + beta x (E(Rm) - Rf).”
- Contrast the parts that make up an interest rate
“A nominal interest rate can be decomposed into a real risk-free rate plus premiums for the risks the lender takes: expected inflation, default, liquidity and maturity.”
- Explain what adding a risk-free asset does, and the capital allocation line
“If investors share the same expectations and can borrow and lend at the risk-free rate, each holds some mix of the risk-free asset and that same tangency portfolio, varying only the proportions — lending at the risk-free rate for a conservative position, borrowing to move beyond the tangency point for an aggressive one.”
- Outline the main types of private debt
“Returns come from a spread over the risk-free rate that compensates for illiquidity and credit risk, and most direct lending is floating rate, so the exposure is to credit rather than to duration.”
See also
Learn it properly
Practise it
Practise risk-free rate until it is automatic: questions that explain every wrong option.
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