Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. One interpretation is that the risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time. Another interpretation is that the risk free rate is the compensation that would be demanded by a representative investor holding a representative market portfolio, comprising all the assets in the economy, (i.e. the risk free rate is the compensation for systemic risk which cannot be eliminated by holding a diversified portfolio.) It is the second interpretation which is applied in the Capital Asset Pricing Model. (Refer to The Econometrics of Financial Markets, by Campbell, Lo and MacKinlay.)
Since the risk free rate can be obtained with no risk, it is implied that any additional risk taken by an investor should be rewarded with an interest rate higher than the risk-free rate.
Read more about Risk-free Interest Rate: Theoretical Measurement of The Risk Free Rate, Proxies For The Risk-free Rate, Application
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