Risk-free bond
Encyclopedia
A risk-free bond is a theoretical bond
that repays interest
and principal with absolute certainty. The rate of return would be the risk-free interest rate
. In practice, government bond
s are treated as risk-free bonds, as governments can raise taxes or indeed print money to repay their domestic currency debt. For instance, United States Treasury notes and United States Treasury bonds are considered risk-free bonds, even though investors in United States Treasury securities do face a negligible amount of credit risk
. An example of this credit risk was shown by Russia
, who defaulted on its domestic debt in 1998.
according to formulas like Black–Scholes a risk-free bond would be purchased (or sold) accordingly.
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
that repays interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
and principal with absolute certainty. The rate of return would be the risk-free interest rate
Risk-free interest rate
Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
. In practice, government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
s are treated as risk-free bonds, as governments can raise taxes or indeed print money to repay their domestic currency debt. For instance, United States Treasury notes and United States Treasury bonds are considered risk-free bonds, even though investors in United States Treasury securities do face a negligible amount of credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
. An example of this credit risk was shown by Russia
Russia
Russia or , officially known as both Russia and the Russian Federation , is a country in northern Eurasia. It is a federal semi-presidential republic, comprising 83 federal subjects...
, who defaulted on its domestic debt in 1998.
Application
When hedgingHedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
according to formulas like Black–Scholes a risk-free bond would be purchased (or sold) accordingly.