what is the risk free rate of return 
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 the so called real risk free rate can be calculated by subtracting the current inflation rate from the yield of the treasury bond matching your investment duration investopedia ellen lindnerunderstanding the risk free rate of returnin theory the risk free rate is the minimum return an investor expects for any investment investors will not accept additional risk unless the potential rate of return is greater than the risk free rate if you are finding a proxy for the risk free rate of return you must consider the investor s home market negative interest rates can complicate the issue in practice a truly risk free rate does not exist because even the safest investments carry some small amount of risk different countries and economic zones use different benchmarks as their risk free rate the interest rate on a three month u s treasury bill t bill is often used as the risk free rate for u s based investors the three month u s treasury bill is a useful proxy because the market considers there to be virtually no chance of the u s government defaulting on its obligations the large size and deep liquidity of the market contribute to the perception of safety a foreign investor whose assets are not denominated in dollars incurs currency risk when investing in u s treasury bills the risk can be hedged via currency forwards and options but affects the rate of return the short term government bills of other highly rated countries such as germany and switzerland offer a risk free rate proxy for investors with assets in euros eur or swiss francs chf investors based in less highly rated countries that are within the eurozone such as portugal and greece are able to invest in german bonds without incurring currency risk by contrast an investor with assets in russian rubles cannot invest in a highly rated government bond without incurring currency risk importance of risk free ratethe risk free rate serves as a fundamental building block in finance as it has a role in financial modeling investing and valuations as a baseline rate it provides a benchmark against which the return on all other investments is measured in valuation models such as discounted cash flow analysis this is used as the discount rate to determine the present value of future cash flowsthe risk free rate also helps price financial instruments and determine appropriate rates of return for investment strategies for instance it influences the pricing of bonds options and derivatives as it s a key input in pricing models the risk free rate also plays a part in cost of capital calculations it helps companies assess the required return on investment projects and determine their optimal capital structure based on what that company could earn should it choose to not take on any risk last the risk free rate is important to investors by comparing the expected return of an investment to the risk free rate investors can assess whether the potential return justifies the level of risk taken for example if you knew you could earn 5 risk free what amount of risk would you be willing to take on to earn a 7 return would that amount of risk change if you knew you could only earn a risk free rate of 2 risk free rate and financial asset pricingin valuation models such as the capital asset pricing model capm the risk free rate is used as the baseline rate of return against which the expected returns of risky assets are compared according to capm the expected return of an asset is determined by adding a risk premium which compensates investors for bearing additional risk to the risk free rate as a result changes in the risk free rate directly influence the required rate of return for risky assets in bond pricing the risk free rate determines bond yields bonds are priced based on their present value which is calculated by discounting future coupon payments and principal repayment using the prevailing risk free rate when the risk free rate increases the present value of future cash flows decreases leading to a decline in bond prices and an increase in bond yields the opposite is true when the risk free rate decreases the pv of cash flow goes up and so does the bond s price as touched on earlier the risk free rate also influences the pricing of options and other derivatives through models such as the black scholes model the risk free rate is an input in these types of option pricing models and the risk free rate just like with other models affects the value of options by influencing the cost of carrying the underlying asset factors that influence the risk free ratethe risk free rate is complex there are a lot of variables that contribute to what that rate is and the risk free rate is subject to fluctuations very broadly speaking some of the high level factors that influence the risk free rate include proxies for the risk free rateseveral alternatives are commonly used to represent the risk free rate in financial analysis and valuation if you can t seem to get ahold of the risk free rate or need a close alternative some of those proxies include limitations of risk free ratewhile the risk free rate is a real and important concept in financial analysis it has several limitations that investors and analysts should consider the risk free rate assumes risk neutrality meaning it represents the return an investor can earn without taking on any risk however in reality all investments involve some degree of risk even if it s a really really small amount of risk think about how even the largest governments in the world could fail due to uncertain situations the risk free rate is also influenced by various market factors including monetary policy decisions economic conditions and investor sentiment changes in these factors can lead to fluctuations in the risk free rate over time meaning it can be hard to use it as a stable benchmark for long term financial analysis in addition inflation erodes the purchasing power of money over time meaning that the real inflation adjusted risk free rate may be lower than the nominal rate the risk free rate varies across countries and currencies what could be the risk free rate in the united states may be different than the risk free rate in russia this reflects differences in economic conditions monetary policies and geopolitical risk using a single risk free rate for all countries may not properly reflect the riskiness of certain markets or geographical regions last certain proxies for the risk free rate like the ones above may not fully reflect liquidity risk in times of market stress or financial crises liquidity in these markets may dry up this means the price of these goods may dramatically increase and cause the rate of return to substantially decrease meaning there could be some volatility in the risk free rate as well 