What is the Risk Free Rate?

Figure 1

It may seem surprising to talk about a risk free rate. Especially as we’ve gone to such great lengths to explain that it’s not possible to earn a reward without taking risk, so how can there be a risk free rate?

In financial markets the term risk free rate is a shorthand for saying the theoretical credit risk free interest rate¹. It is the interest rate you could theoretically earn if you lend your assets with complete certainty they would be returned². There’s only one type of entity that you can lend money to and know that they can give it back to you in the future, and that entity is the central government. How can we be sure that the government will have enough money to repay us in the future? Simple, if they don’t, they will just print³ some new money and use that to pay us back.

The interest on government bonds must be 0% right?

Nope, even governments have to pay interest on their borrowings. After all, no one likes to lend money for free!

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Why Isn’t The Risk Free Rate 0%?

Time Value Of Money

If you have a choice between having $100 now or $100 one year from now, I would hope most people would choose to have the money now. It’s always better to have the money now, because you can spend it whenever you like, you don’t have to wait. Even if you are not the kind of person that likes to go shopping it’s still better to have the money now. What if your car breaks down? Having that $100 in your pocket sure would come in handy to pay for repairs. All this means, if someone wants to borrow money from you for a year, they will have to pay you enough interest to compensate you for the inconvenience of not having use of that $100 for the entire year. So even risk free, there’s going to be an interest rate.

Now let’s look at another reason the interest isn’t 0%. If you have the $100 with you now, you can use it to buy a hamper of long life food. But if you give it to the government for a year, you will have to wait until next year to buy that same hamper. You know that the hamper costs $100 now, but because of inflation, you expect the same hamper to be $102 next year. If the interest rate paid by the government was 0%, everyone would buy their hampers now, and not lend them any money. So the government would have to pay at least what people believe the rate of inflation will be.

The inconvenience of not having access to your money, and also the impact of inflation, all add to the interest rate that the government will have to pay to you in order to borrow money. But that’s not the end of the story. It turns out that, even though we call it the (credit) risk free interest rate, there still is credit risk when you lend to a government!

Credit Risk

The theory says that a government can simply print new money to pay you back, so how can there be any credit risk? It comes about in a couple of ways. First, the government may not actually have access to the central bank printing press. For instance, if a government issues bonds in a foreign currency it won’t have access to that foreign currency printing press, an example might be a South American country borrowing money in United States Dollars. Second, even if a government does have access to the printing press, it might choose not to use it, it might even prefer to default⁴ instead. Governments often have internal disputes about public deficits, and they can lead to situations where the debt might not be repaid when due. The most notable example of such a situation was the rating downgrade of the United States⁵. The very reason it was so notable was simply because nobody believed that the US government would or could default on its debt.

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Why is the Risk Free Rate Important?

It Influences All Other Interest Rates

The government (sometimes called the sovereign) borrowing rate in their own domestic currency, is almost always the lowest borrowing interest rate in that economy. We know if we lend to the government they can repay us by producing more money magically out of thin air, so, in theory, it must be the lowest credit risk in that economy. But if we lend to anyone else, we must be taking additional credit risk above and beyond the central government credit risk, so they will have to pay us more interest to compensate or entice us to lend to them. This makes it convenient to use the government borrowing rates as the baseline rate of the economy.

With every other rate in a given economy usually greater than the corresponding risk free rate⁶. A government can change interest rates across the board by simply changing their risk free rate. Deposit rates, mortgage rates, interbank rates, corporate loan rates, you name it, they all adjust when the risk free rate changes.

The risk free rate crops up in every single area of the financial system including:

1. Currency Exchange Rates
2. Derivative Pricing
3. Loan And Bond Pricing
4. Prices Of Stocks And Shares

Most of the key formulas used in financial markets to determine present value or future value of any security will rely on at least the risk free rate and time as part of any calculation. It’s impossible to overstate how important the risk free rate is to an economy, without it almost nothing would work.

Footnotes

1. In reality it isn’t even credit risk free! ↩

2. Well, as complete a certainty as possible with respect to a given economy and its domestic currency. ↩

3. These days, instead of printing bank notes, they simply add an entry to a digital ledger. ↩

4. Default is a technical term that means the borrower fails to meet its financial obligations, like not paying money when due. ↩

5. See United States federal government credit-rating downgrades. ↩

6. You might find interest rates that are less than the risk free rate, for example with bank accounts, but you’ll find that the interest rate that those same banks need to pay to borrow money in the wholesale markets is generally greater than the risk free rate. They can get away with giving you less interest on your accounts because they are essentially charging you for their banking services, which reduces the interest rate below the risk free rate. ↩