What is the risk-free rate?

The risk-free rate is the return an investor can earn without taking any meaningful risk of loss. It is the baseline every other investment is judged against: taking risk only makes sense if it is expected to pay more than what is available without it.

No investment is entirely free of risk, so in practice the risk-free rate is approximated by the interest on very safe, short-term instruments.

Which rate is used

For euro investors, common choices are:

€STR, the euro short-term rate: the overnight rate at which large banks lend to each other, published by the European Central Bank,
short-term German government bills, considered among the safest euro assets,
the ECB deposit facility rate, which the short-term market rates follow closely.

For US dollar investors, three-month US Treasury bills are the usual reference.

Where it enters the formulas

The excess return of a portfolio is its return above the risk-free rate:

\text{Excess return} = R_p - R_f

The Sharpe ratio divides that excess return by the portfolio's volatility:

S = \frac{R_p - R_f}{\sigma_p}

And in the capital asset pricing model, the expected return of an investment with market sensitivity $\beta$ is the risk-free rate plus a reward for market risk:

E[R] = R_f + \beta \, (E[R_m] - R_f)

A simple illustration

A portfolio returns 6% in a year. With a risk-free rate of 0%, all six points are a reward for taking risk. With a risk-free rate of 4%, only two are — the rest could have been earned in a money market fund. The same 6% is a good result in the first case and a modest one in the second.

Why it changes the picture

The ECB's deposit rate was below zero from 2014 to 2022 and then rose to 4% in 2023. That swing shows how much the baseline can move:

Cash is not always a zero-return asset. When rates are high, cash earns a meaningful return, and the bar for risky investments rises with it.
Risk-adjusted measures shift. A Sharpe ratio from a period of negative rates is not directly comparable with one from a period of 4% rates.
Risk-free is not inflation-proof. In 2022, safe short-term rates were far below inflation, so the risk-free investment had a clearly negative real return.

See these numbers for your own portfolio

Floreo works out every figure on this page from your own holdings — returns, risk, allocation, currencies — and the assistant explains them the way this page does. Import from your broker, or try it on the sample portfolio first.

Start Demo

The demo opens straight away on a sample portfolio — no account needed.