What Is a Risk-Free Asset?
Let me explain to you what a risk-free asset is—it's one that delivers a certain future return with virtually no possibility of loss. You can think of debt obligations from the U.S. Department of the Treasury, like bonds, notes, and especially Treasury bills, as risk-free because they're backed by the full faith and credit of the U.S. government. Since they're so safe, the return on these assets stays very close to the current interest rate.
Many academics argue that nothing in investing is 100% guaranteed, so technically, there's no true risk-free asset. This might be accurate because all financial assets carry some danger—they could drop in value or become worthless. But for the average investor, the risk is so tiny that it's fair to treat U.S. Treasurys or government debt from stable Western nations as risk-free.
Key Takeaways
- A risk-free asset has a certain future return with virtually no chance it will drop in value or become worthless.
- These assets offer low rates of return since their safety means investors don't need extra compensation for risk.
- They're guaranteed against nominal loss, but not against losing purchasing power due to inflation.
- Over the long term, they may face reinvestment risk.
Understanding a Risk-Free Asset
When you take on an investment, you expect a certain return based on how long you hold it. The risk comes in because the actual return might differ greatly from what you anticipated. Market fluctuations are tough to predict, so that unknown future return is the risk. Higher risk usually means bigger swings, which could lead to big gains or losses depending on how things turn out.
Risk-free investments are reasonably certain to hit the predicted gain level. Since the gain is basically known, the return rate is often much lower to match the low risk. The expected and actual returns are likely to be very similar.
Even though the return on a risk-free asset is known, it doesn't guarantee a profit in terms of purchasing power. Depending on the time to maturity, inflation can erode the asset's buying power even if its dollar value rises as expected.
Risk-Free Assets and Returns
The risk-free return is the theoretical return from an investment with zero risk and a guaranteed outcome. This rate shows the interest you'd expect on your money from a risk-free asset over a set period. For instance, investors often use the interest rate on a three-month U.S. T-bill as a stand-in for the short-term risk-free rate.
This risk-free return is the benchmark against which other returns are measured. If you buy a security with more risk than a risk-free asset like a U.S. Treasury bill, you'll demand a higher return for that extra chance you're taking. The difference between the earned return and the risk-free return is the risk premium. In essence, you add the risk-free return to a risk premium to get the total expected return on an investment.
Reinvestment Risk
While risk-free assets aren't likely to default, they do have a weakness called reinvestment risk. For a long-term investment to stay risk-free, any needed reinvestment must also be risk-free. Often, you can't predict the exact return rate from the start for the whole investment duration.
For example, suppose you invest in six-month Treasury bills twice a year, replacing each maturing batch with a new one. The risk of hitting the specified return for each six-month period on a particular T-bill is basically zero. But interest rates can change between reinvestments. So the return on the second T-bill might not match the first, the third might differ from the second, and so on. Over the long term, there's some risk—even though each individual T-bill's return is guaranteed, the overall rate over a decade or whatever period you follow this strategy isn't.
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