Definition of Risk Free Interest Rate

The risk-free rate is the interest rate that is guaranteed by the borrower as there is no default risk involved. The risk-free rate is typically the interest rate on government bonds. Since the government will never default, there is no default risk in investing money in government bonds.

The risk-free rate is often used by many bonds when they add a premium on the risk-free rate. To understand this, let’s take an example. The floating rate of return may be based on an underlying borrowing rate plus a premium, such as LIBORE plus 2%. Similarly, when the bond rates are quoted the rate of return is quoted as Rf% + 3%. In case the rate of interest offered by the U.S. government on 6 months bond is 4%, the rate of return in the above example will be 7% (4%+3%).