Most risk and return models in finance start off with an asset that is defined as risk free and use the expected return on that asset as the risk free rate. The expected returns on risky investments are then measured relative to the risk free rate, with the risk creating an expected risk premium that is added on to the risk free rate. But what makes an asset risk free? And what do we do when we cannot find such an asset?

An asset is riskfree if we know the expected returns on it with certainty û i.e. the actual return is always equal to the expected return. Under what conditions will the actual returns on an investment be equal to the expected returns? There are two basic conditions that have to be met. The first is that there can be no default risk. Essentially, this rules out any security issued by a private firm, since even the largest and safest firms have some measure of default risk. The only securities that have a chance of being risk free are government securities, not because governments are better run than corporations, but because they control the printing of currency. At least in nominal terms, they should be able to fulfil their promises.
Even though this assumption is straightforward , it does not always hold up, especially when governments refuse to honour claims made by previous regimes and when they borrow in currencies other than their own.

There is a second condition that riskless securities need to fulfil that is often forgotten. For an investment to have an actual return equal to its expected return, there can be no reinvestment risk.
To illustrate this point, assume that you are trying to estimate the expected return over a ten-year period and that you want a risk free rate. A short-term (up to 5 years) government stock, while default free, will not be risk free, because there is the reinvestment risk of not knowing what the return on such stock will be in 5 years. On a practical level, re-investment risk over a long-period has little effect when discounted in present value calculations. So the return on a long-term (10 years or more) government bond is an adequate measure of riskless return.

The risk free rate should be measured consistently with how the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the risk free rate will be the US treasury bond rate.