Risk-Free Rate

The risk-free rate is the return an investor can earn on an asset that carries no risk of default and pays a known amount over a set period. No asset is perfectly safe, so in practice the rate is represented by a proxy: short-term government debt such as US Treasury bills, or an overnight benchmark rate set in a deep money market. It is the starting point for valuing almost every other financial asset.

Finance treats the risk-free rate as the price of time alone. Every riskier return is described as the risk-free rate plus a premium, whether that premium is a credit spread on a corporate bond or the equity risk premium on shares. The term is not the same as a central bank's policy rate, although the two usually move together, and it differs between currencies, which is why an interest rate differential exists.

Think of the safest place you could possibly leave your savings for three months: a place where you are certain to get every penny back, plus a small, guaranteed fee for the wait. Whatever that fee is, it becomes your yardstick. Any other use of your money has to pay more than that, or there is no reason to take the extra risk.

For most investors, lending to their own government for a short time is that safe place. The government can raise taxes and, in its own currency, cannot run out of money to pay its debts. So the rate it pays on short loans becomes the floor that every company, bank and homebuyer is measured against. When that floor rises, borrowing gets dearer for everyone.

• Treasury bills. The yield on three-month US Treasury bills is the classic proxy in American finance, because the bills are short, liquid and backed by the federal government.
• Longer government bonds. For valuing long-lived assets, analysts often use the yield on a ten-year government bond, which matches the horizon better but includes a term premium.
• Real rates. Inflation-protected bonds, such as US Treasury Inflation-Protected Securities, give a real risk-free rate that strips out expected inflation.
• Overnight benchmarks. Derivatives and loans now reference overnight rates set by central banks or their agents.

For decades bank loans and swaps were priced off LIBOR, a rate built from banks' own estimates of their borrowing costs, which carried bank credit risk and proved open to manipulation. Regulators pushed markets to adopt nearly risk-free overnight rates instead, and the last LIBOR settings ended on 30 September 2024. The main replacements are:

• United States. SOFR, published by the Federal Reserve Bank of New York since April 2018 and based on overnight repo transactions backed by Treasuries.
• Euro area. The euro short-term rate (€STR), published by the European Central Bank since 2 October 2019 from unsecured overnight borrowing by banks.
• United Kingdom. SONIA, administered by the Bank of England, which reformed its method in April 2018.

Japan uses TONA, the Tokyo overnight average rate published by the Bank of Japan, and Switzerland uses SARON, administered by SIX. Each is a near risk-free rate for its own currency, which is why the risk-free rate is always currency-specific: a euro investor and a dollar investor start from different floors.

The capital asset pricing model, developed by William Sharpe and others in the 1960s, uses the risk-free rate as its base. The expected return on an asset is:

• $E(R_{i})$ is the expected return on asset $i$.
• $R_{f}$ is the risk-free rate.
• $\beta_{i}$ measures how strongly the asset moves with the overall market.
• $E(R_{m})$ is the expected return on the market, so $E(R_{m}) - R_{f}$ is the market risk premium.

With a risk-free rate of 4 percent, a beta of 1.2 and an expected market return of 9 percent, the required return is $4\% + 1.2 \times (9\% - 4\%) = 10\%$. The same rate is used to discount cash flows in present-value models, in option pricing and in the compound interest calculations that set bond prices.

The risk-free label is a convenience, not a guarantee. Governments can default on debt in a currency they do not issue, as many sovereign defaults show, and even the United States has lost its top rating at S&P in 2011, Fitch in 2023 and Moody's in 2025. A bill that is free of default risk still carries inflation risk and reinvestment risk. Rates can also fall below zero, as negative interest rates in the euro area and Japan did in the 2010s. And until the 1951 Treasury-Fed Accord, US government yields were capped by the central bank, so the market "risk-free" rate was partly an administered price.

• Federal Reserve Bank of New York: Secured Overnight Financing Rate
• European Central Bank: Euro short-term rate (€STR)
• Bank of England: SONIA interest rate benchmark