What is a Risk-Free Asset?
A risk-free asset is one that guarantees a certain future return with virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (such as bonds, notes, and particularly Treasury bills) are considered risk-free assets due to being backed by the ‘full faith and credit’ of the U.S. government. Due to their secure nature, the returns on risk-free assets generally align closely with the prevailing interest rate.
Many experts argue that no investment is absolutely risk-free as some degree of risk exists in all financial assets, whether due to their potential to drop in value or become worthless. However, for the average investor, U.S. Treasury securities or government debt from stable Western nations are deemed sufficiently risk-free.
Key Takeaways
- A risk-free asset guarantees a future return with no significant danger of loss.
- These assets typically offer lower returns, as their safety negates the need for compensating for risk.
- Although safeguarded against nominal loss, risk-free assets are not immune to losses in purchasing power.
- Over the long-term, risk-free assets may also face reinvestment risk, where the future rate of return cannot be accurately predicted.
Understanding a Risk-Free Asset
When investors engage in an investment, they anticipate a certain rate of return over the expected holding duration. The risk lies in the potential discrepancy between the anticipated and actual return. Unknown factors causing market fluctuations represent this risk. Generally, a higher level of risk accompanies a heightened likelihood of significant gains or losses.
Risk-free investments are considered nearly certain to yield returns at the predicted level. Since the return is essentially known, the rate is typically lower to reflect the minimized risk. The expected and actual returns are almost identical.
However, the certainty of return does not ensure protection against inflation, which could erode purchasing power even if the investment appreciates as expected in dollar terms.
Risk-Free Assets and Returns
Risk-free return represents the theoretical earnings attributed to a guaranteed zero-risk investment. It is the interest investors expect from a risk-free asset over a specific period. For instance, the three-month U.S. T-bill rate serves as a common benchmark for the short-term risk-free rate.
This risk-free return serves as a baseline for evaluating other investment returns. Investors selecting assets with higher risk than a risk-free asset (like a U.S. Treasury bill) will naturally demand higher returns to compensate for the elevated risk. The difference between the earned return and the risk-free return is the risk premium, translating to expected returns combining the risk-free return and the risk premium.
Reinvestment Risk
Even though risk-free assets are almost devoid of default risk, they are not free from reinvestment risk. For a long-term strategy, maintaining a risk-free status necessitates that any reinvestments are also risk-free. However, the rate of return may not be predictable over the entire investment period.
For example, an investor buying six-month Treasury bills twice a year faces almost no risk for each bill. However, interest rates may fluctuate upon each reinvestment. Consequently, while the first T-bill’s return is guaranteed, subsequent investments may not match previous rates. Therefore, while individual T-bills assure certain returns, the holistic rate of return over extended periods is uncertain.
Related Terms: Assets, Interest Rate, Rate of Return, Reinvestment Risk, Risk Premium.
