Application
The risk-free interest rate is highly significant in the context of the general application of Modern Portfolio Theory which is based on the Capital Asset Pricing Model. There are numerous issues with this model, the most basic of which is the reduction of the description of utility of stock holding to the expected mean and variance of the returns of the portfolio. In reality, there may be other utility of stock holding, as described by Shiller in his article 'Stock Prices and Social Dynamics,' (1984) Brooking Papers on Economic Activity, pages 457 to 511.
The risk free rate is also a required input in financial calculations, such as the Black–Scholes formula for pricing stock options and the Sharpe Ratio. Note that some finance and economic theories assume that market participants can borrow at the risk free rate; in practice, of course, very few (if any) borrowers have access to finance at the risk free rate.
Read more about this topic: Risk-free Interest Rate
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