The Real Risk Free Rate of Interest r

The real risk-free rate of interest, r*, is defined as the interest rate that would exist on a riskless security if no inflation were expected, and it may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world. The real risk-free rate is not static—it changes over time depending on economic conditions, especially (1) on the rate of return corporations and other borrowers expect to earn on productive assets and (2) on people's time preferences for current versus future consumption. Borrowers' expected returns on real asset investments set an upper limit on how much they can afford to pay for borrowed funds, while savers' time preferences for consumption establish how much consumption they are willing to defer, hence the amount of funds they will lend at different interest rates. It is difficult to measure the real risk-free rate precisely, but most experts think that r* has fluctuated in the range of 1 to 5 percent in recent years.10

In addition to its regular bond offerings, in 1997 the U.S. Treasury began issuing indexed bonds, with payments linked to inflation. To date, the Treasury has issued ten of these indexed bonds, with maturities ranging (at time of issue) from 5 to 31 years. Yields on these bonds in November 2001 ranged from 0.94 to 3.13 percent, with the higher yields on the longer maturities because they have a maturity risk premium due to the fact that the risk premium itself can change, leading to changes in the bonds' prices. The yield on the shortest-term bond provides a good estimate for r*, because it has essentially no risk.

See http://www. bloomberg.com and select MARKETS and then U.S. Treasuries for a partial listing of indexed Treasury bonds. The reported yield on each bond is the real risk-free rate expected over its life.

10The real rate of interest as discussed here is different from the current real rate as discussed in connection with Figure 1-5. The current real rate is the current interest rate minus the current (or latest past) inflation rate, while the real rate, without the word "current," is the current interest rate minus the expected future inflation rate over the life of the security. For example, suppose the current quoted rate for a one-year Treasury bill is 5 percent, inflation during the latest year was 2 percent, and inflation expected for the coming year is 4 percent. Then the current real rate would be 5% — 2% = 3%, but the expected real rate would be 5% — 4% = 1%. The rate on a 10-year bond would be related to the expected inflation rate over the next

10 years, and so on. In the press, the term "real rate" generally means the current real rate, but in economics and finance, hence in this book unless otherwise noted, the real rate means the one based on expected inflation rates.

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Responses

  • Bandobras
    What is current risk free interest rate?
    8 years ago
  • calum macleod
    What is real risk free rate of interest?
    8 years ago
  • bisrat
    Why is it hard to measure real rate of interest?
    8 years ago

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