Options Glossary

Last Updated: May 10, 2015

Glossary

What Does Risk-free Interest Rate Mean in Options Trading?

The** Risk-free interest rate** is the return on investment with no loss-of-capital risk. In practice, this does not exist because any investment carries an amount of risk—even the safe ones. In theory, it is an important parameter in option pricing as it sets the baseline price upon which risk premium should be added. A practical estimate to the risk-free interest rate is taken from 'risk-free' bond issued by the government or agency where the default risk is practically zero.

In theory, however; it is an important parameter in option pricing because this sets the baseline price upon which risk premium should be added. A practical estimate to the risk-free interest rate is taken from 'risk-free' bond issued by the government or agency where the default risk is practically zero.^{}

Since the risk-free rate can be obtained with no risk, any other investment will have an additional risk and additional return. In options trading, this parameter is required in the Black-Scholes model and similar option pricing models. However, as long as the risk-free interest rate is held constant when comparing options, it should have a consistent effect on the pricing, and therefore it is not critical when making a comparison between similar contracts.

Synonyms:

risk-free rate, risk-free rate of return