Reviewed by Gotrade Internal Analyst
If you invest in stocks, bonds, or funds, you are always taking some level of risk. Prices can move against you, returns can vary, and outcomes are never guaranteed. To understand whether a return is worth the risk, investors need a baseline. This baseline is known as the risk free rate.
The risk free rate plays a quiet but critical role in investing. It is used to compare investments, calculate expected returns, and measure whether taking risk is justified.
This guide explains the risk free rate meaning, how it is determined, and why investors care about it in everyday decision making.
What Is the Risk Free Rate?
The risk free rate is the theoretical return an investor can earn with no risk of losing money.
In simple terms, it represents the return you could earn from an investment that is considered extremely safe, with virtually no chance of default.
In practice, truly risk free investments do not exist. However, government securities issued by financially stable countries are often used as a close approximation.
In the US market, the risk free rate is commonly based on:
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US Treasury bills for short term analysis
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US Treasury notes or bonds for longer term analysis
How Does the Risk Free Rate Work?
The risk free rate acts as a reference point for all other investments. Any risky investment is expected to offer a return above this rate as compensation for uncertainty.
1. It reflects the return on safe assets
Short term US Treasury bills are backed by the US government and are widely viewed as having minimal default risk. Their yields are often used as the risk free rate.
2. It changes over time
The risk free rate is not fixed. It moves with interest rates, inflation expectations, and central bank policy.
When interest rates rise, the risk free rate increases. When rates fall, the risk free rate declines.
3. It sets the minimum expected return
If an investment does not offer a return meaningfully higher than the risk free rate, many investors may decide the risk is not worth taking.
Risk Free Rate Formula Explained
The risk free rate itself does not require a complex formula. It is usually observed directly from government bond yields.
However, it plays a key role in many investing formulas.
A simple example of how it is used:
Expected return = Risk free rate + Risk premium
The risk free rate formula is often embedded inside models such as:
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Capital asset pricing model (CAPM)
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Discounted cash flow analysis
In these models, the risk free rate represents the starting point before adding compensation for risk.
Why the Risk Free Rate Matters to Investors
It helps evaluate investment returns
By comparing an investment’s return to the risk free rate, investors can see whether taking risk was rewarded.
If a stock returns 6 percent while the risk free rate is 5 percent, the extra return may not justify the volatility.
It influences asset allocation
When the risk free rate is high, safe assets become more attractive. When it is low, investors may be pushed toward riskier assets to seek higher returns.
It affects valuation models
The risk free rate is used to discount future cash flows. Changes in the rate can significantly impact stock and bond valuations.
It reflects broader economic conditions
Rising risk free rates often signal tighter monetary policy. Falling rates usually reflect economic slowdown or stimulus efforts.
Risk Free Rate vs Inflation
The risk free rate is a nominal figure. Inflation reduces the real value of returns.
If the risk free rate is 4 percent and inflation is 3 percent, the real return is only about 1 percent.
This is why investors often consider both the risk free rate and inflation when evaluating long term purchasing power.
Limitations of the Risk Free Rate
The risk free rate has important limitations.
- It assumes government debt is free from default risk.
- It does not account for inflation uncertainty.
- It varies by country and currency.
For global investors, choosing the correct risk free rate depends on the market and currency being analyzed.
Conclusion
The risk free rate represents the baseline return investors can expect without taking meaningful risk. It is a key reference point for comparing investments, measuring performance, and understanding market conditions.
By understanding how the risk free rate works, investors can make more informed decisions about whether taking additional risk makes sense.
If you want to start evaluating investments in the US market, you can explore US stocks and ETFs through the Gotrade app. Fractional shares make it easier to learn, compare returns, and build your portfolio gradually.
FAQ
What is the risk free rate in simple terms?
The risk free rate is the return investors expect from a very safe investment, usually based on government bonds.
Is the risk free rate truly risk free?
No investment is completely risk free, but government securities from stable countries are often used as a close approximation.
Why does the risk free rate change?
It changes due to interest rates, inflation expectations, and central bank policy decisions.
Which risk free rate should investors use?
It depends on the time horizon and market. US Treasury bills are commonly used for short term analysis, while longer bonds are used for long term models.
Reference:
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Investopedia, Understanding Risk-Free Rate, 2026.
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Federal Reserve Bank of St. Louis, Treasury Yields and Interest Rates, 2026.
Disclaimer
Gotrade is the trading name of Gotrade Securities Inc., which is registered with and supervised by the Labuan Financial Services Authority (LFSA). This content is for educational purposes only and does not constitute financial advice. Always do your own research (DYOR) before investing.
