Question

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What is meant by the term risk-free interest? Why is the U.S. Treasury bill yield used as the risk free interest rate?

Answer 1

Risk Free interest or Risk Free rate of Return, in theory, is a rate of return which can be earned without taking any risk at all over a period of time.

This is the Investment which is highly secured and is backed by Govt. Though this rate doesn't truly exist because any investment cant be isolated from risk. So no matter how small but there is always a risk. So, in theory Risk free rate is min return that can be earned without taking any risks.

The US Treasury bill yield is generally used as risk free interest rate because it is backed up by the Fed, The US Govt. So if there is any loss that will be compensated by the govt. and Govt dont make any defaults in making payments to its lenders. So this kind of Investment is considered as Risk free but if there is still risk in case the Govt goes bankrupt.

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