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Importance of Investments

Risk Free Interest Rate

In this section, let us discuss another concept related to interest rates called "Risk Free Interest Rate''.


What do you understand about the Risk Free Interest Rate?


The real risk-free rate of interest is a theoretical rate on a single period loan that has no expectation of inflation in it. Real rate of return is also known as an investor's increase in purchasing power (after adjusting for inflation). Since expected inflation in future periods is not zero, the rates we observe on G-Sec, for example, are risk-free rates but not real rates of return. G-Sec rates are nominal risk-free rates because they contain an inflation premium.


Nominal risk-free rate = real risk-free rate + expected inflation rate


Equilibrium interest rates are the required rate of return for a particular investment, in the sense that the market rate of return is the return that investors and savers require to get them to willingly lend their funds.


Interest rates, also referred to as discount rates, and the terms are often used interchangeably. If an individual can borrow funds at an interest rate of 20%, then that individual should discount payments to be made in the future at that rate in order to get their equivalent value in money. Interest rates can also be viewed as the opportunity cost of current consumption. If the market rate of interest on one-year securities is 7%, earning an additional 7% is the opportunity forgone when current consumption is chosen rather than saving (postponing consumption).

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Units 14/16