Risk-Free Rate of Return
What it is:
How it works (Example):
Why it Matters:
The notion of a risk-free rate of return is a fundamental component of the capital asset pricing model, the Black-Scholes option pricing model and modern portfolio theory, because it essentially sets the benchmark above which assets that do contain risk should perform. Of course no is truly risk free -- there is always at least some possibility, no matter how minute, that the U.S. government would not be able to repay its debt, for example. But that risk is considered so minute as to be virtually zero.
Regardless of the debate over the true statistical probability of default on risk-free assets, it's important to that the risk-free rate of return is subject to , whereby the returns are eaten away by inflation over time. Also, the risk-free rate of return carries interest-rate risk, meaning that when interest rates rise, Treasury prices fall, and vice versa. Fortunately, in periods of rising interest rates, Treasury prices tend to fall less than other do.