Risk-free rate (risikofreier Zins)
The risk-free rate is the return on an investment assumed to carry no default risk — in practice, the yield on the safest government bonds available, such as German Bunds. Every other expected return in finance gets priced as this baseline plus a premium for the extra risk taken on.
Why it matters
Every investment decision implicitly compares an expected return against some safer alternative. The risk-free rate is that alternative made explicit — it's what an investor gives up by choosing a stock or a corporate bond over the closest thing to a sure repayment. It builds directly on the interest rate (Zinssatz): the risk-free rate is a specific interest rate, applied to a borrower assumed to have essentially zero chance of failing to repay — which is why default-free is the more precise name for it.
The concept also feeds forward into the equity risk premium — the extra return stock investors demand over a safe asset for taking on the risk of owning a company rather than lending to a government. Without a risk-free rate as the starting point, "extra return for extra risk" has no baseline to measure from.
Worked examples
1. Reading a risk-free rate. An illustrative risk-free rate of 2.5% per year means a 10-year German Bundesanleihe (federal government bond) held to maturity is assumed to pay 2.5% annually, with no realistic scenario in which Germany fails to repay. On €10,000 invested: €10,000 x 0.025 = €250 per year, before tax.
2. Building other returns on top of it. Riskier assets get priced as the risk-free rate plus a premium sized to the extra uncertainty. Using the same illustrative 2.5% risk-free rate as the base:
| Asset | Risk-free rate | Risk premium (illustrative) | Expected return |
|---|---|---|---|
| German Bundesanleihe (10-year) | 2.5% | 0% — this is the baseline | 2.5% |
| Investment-grade corporate bond | 2.5% | +1% for credit risk | 3.5% |
| Diversified stock portfolio | 2.5% | +5% (equity risk premium) | 7.5% |
None of these figures are current market rates — they illustrate the structure, not a quote. The premium grows with the uncertainty of getting paid back in full and on time: a government with its own tax base and currency is judged less likely to default than a single company, and a company's fixed bond payment is judged more certain than a stock's variable, residual claim on profits.
In practice, no asset is perfectly risk-free, and "risk-free" describes default risk specifically — the near-zero chance the issuer fails to repay — not every risk an investor faces. Even top-rated government bonds carry inflation risk, and bonds sold before maturity carry price risk if interest rates move. In real, inflation-adjusted terms a risk-free instrument may not exist at all at certain times: when inflation runs above the nominal risk-free yield, even the safest bond locks in a loss of purchasing power. Default-free is not the same as purchasing-power-free.
Check yourself
A German Bundesanleihe offers an illustrative risk-free rate of 2.5% per year. A diversified stock portfolio's expected return is priced as this risk-free rate plus a 5-percentage-point equity risk premium. What is the stock portfolio's expected annual return, in percent?
What does "risk-free" specifically refer to in "risk-free rate"?
Which of these can still affect a "risk-free" government bond, even though it carries essentially no default risk? (Select all that apply.)
How is the expected return on a riskier asset typically constructed relative to the risk-free rate?