What Is a Risk-Free Asset?
A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them. Because they are so safe, the return on risk-free assets is very close to the current interest rate.
Many academics say that, when it comes to investing, nothing can be 100% guaranteed—and so there's no such thing as a risk-free asset. Technically, this may be correct: All financial assets carry some degree of danger—the risk they will drop in value or become worthless altogether. However, the level of risk is so small that, for the average investor, it is appropriate to consider U.S. Treasurys or any government debt issued by a from stable Western nation to be risk-free.
key takeaways
- A risk-free asset is one that has a certain future return—and virtually no possibility they will drop in value or become worthless altogether.
- Risk-free assets tend to have low rates of return, since their safety means investors don't need to be compensated for taking a chance.
- Risk-free assets are guaranteed against nominal loss, but not against a loss in purchasing power.
- Over the long-term, risk-free assets may also be subject to reinvestment risk.
Understanding a Risk-Free Asset
When an investor takes on an investment, there is an anticipated return rate expected depending on the duration the asset is held. The risk is demonstrated by the fact that the actual return and the anticipated return may be very different. Since market fluctuations can be hard to predict, the unknown aspect of the future return is considered to be the risk. Generally, an increased level of risk indicates a higher chance of large fluctuations, which can translate to significant gains or losses depending on the ultimate outcome.
Risk-free investments are considered to be reasonably certain to gain at the level predicted. Since this gain is essentially known, the rate of return is often much lower to reflect the lower amount of risk. The expected return and actual return are likely to be about the same.
While the return on a risk-free asset is known, this does not guarantee a profit in regards to purchasing power. Depending on the length of time until maturity, inflation can cause the asset to lose purchasing power even if the dollar value has risen as predicted.
Risk-Free Assets and Returns
Risk-free return is the theoretical return attributed to an investment that provides a guaranteed return with zero risk. The risk-free rate represents the interest on an investor's money that would be expected from a risk-free asset when invested over a specified period of time. For example, investors commonly use the interest rate on a three-month U.S. T-bill as a proxy for the short-term risk-free rate.
The risk-free return is the rate against which other returns are measured. Investors that purchase a security with some measure of risk higher than that of a risk-free asset (like a U.S. Treasury bill) will naturally demand a higher level of return, because of the greater chance they're taking. The difference between the return earned and the risk-free return represents the risk premium on the security. In other words, the return on a risk-free asset is added to a risk premium to measure the total expected return on an investment.
Reinvestment Risk
While they're not risky in the sense of being likely to default, even risk-free assets can have an Achilles' heel. And that's known as reinvestment risk.
For a long-term investment to continue to be risk-free, any reinvestment necessary must also be risk-free. And often, the exact rate of return may not be predictable from the beginning for the entire duration of the investment.
For example, say a person invests in six-month Treasury bills twice a year, replacing one batch as it matures with another one. The risk of achieving each specified returned rate for the six months covering a particular Treasury bill's growth is essentially nil. However, interest rates may change between each instance of reinvestment. So the rate of return on the second Treasury bill that was purchased as part of the six-month reinvestment process may not be equal to the rate on the first Treasury bill purchased; the third bill may not equal the second's, and so on. In that regard, there is some risk over the long term. Each individual T-bill's return is guaranteed, but the rate of return over a decade (or however long the investor pursues this strategy) is not.
FAQs
A risk-free asset is one that has a certain future return—and virtually no possibility of loss. Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them.
What are the examples of risk assets? ›
Risk assets are assets that have significant price volatility, such as equities, commodities, high-yield bonds, real estate, and currencies.
Are Treasury bills risk-free assets? ›
T-bills are considered risk-free because you can be certain you'll get your money back. But risk and return are directly proportional, and T-bills offer very low returns on investment. Consequently, if you invest in T-bills, there's a risk you're foregoing the opportunity to earn a higher return elsewhere.
What are risky and non risky assets? ›
A risk asset is an asset that has high volatility in price. Bitcoin and other cryptocurrencies are just some of the risky asset classes. Stocks can be risky as well. However, some assets are still safe and guarantee safe returns.
What are the 4 main asset classes? ›
There are four main asset classes – cash, fixed income, equities, and property – and it's likely your portfolio covers all four areas even if you're not familiar with the term.
What is an example of a risk-free asset? ›
A risk-free asset is an investment with a guaranteed future value and virtually no potential for loss. Debt issued by the U.S. government (bonds, notes and Treasurys) is one of the most well-known risk-free assets.
What are the most risk-free assets? ›
Here are the best low-risk investments in April 2024:
- High-yield savings accounts.
- Money market funds.
- Short-term certificates of deposit.
- Series I savings bonds.
- Treasury bills, notes, bonds and TIPS.
- Corporate bonds.
- Dividend-paying stocks.
- Preferred stocks.
Even cash, as mentioned, carries the risk of losing value because of inflation, and it's also possible that inflation will outpace your investments in Treasurys.
Why is cash a risk-free asset? ›
Cash is available when you need it and, unlike stocks, there's little risk to principal, especially since most savings and checking accounts, CDs and money market deposit accounts (MMDAs) are FDIC-insured for up to $250,000 per depositor.
Are bonds risk-free? ›
No investment is ever 100% risk-free, but government bonds are about as safe as it gets. That's because they're backed by the full faith of the U.S. government. Gains tend to lag behind higher-risk investments, but government bonds can help diversify your portfolio and provide reliable returns.
Safe assets are those that allow investors to preserve capital without a high risk of potential losses. Such assets include treasuries, CDs, money market funds, and annuities.
Which asset has the least risk? ›
Key Takeaways
- Understanding risk, including the risks involved in investing in the major asset classes, is important research for any investor.
- Generally, CDs, savings accounts, cash, U.S. Savings Bonds and U.S. Treasury bills are the safest options, but they also offer the least in terms of profits.
Thus, free assets are calculated as total assets minus liabilities and the minimum solvency margin. A high FAR would generally indicate a strong financial position and surplus capital, while a low FAR would imply a weak balance sheet and possibly a need for an immediate injection of capital.
What asset gives the highest return? ›
Which investment gives high return? Investments in equity or equity-oriented instruments, such as stocks and equity mutual funds, typically offer high returns. However, they come with higher risk compared to fixed-income investments. Real estate and certain types of ULIPs can also offer high returns.
What are the 5 categories of assets? ›
When we speak about assets in accounting, we're generally referring to six different categories: current assets, fixed assets, tangible assets, intangible assets, operating assets, and non-operating assets.
What are Class 5 assets? ›
Class V: Other Tangible Property, including Furniture, Fixtures, Vehicles, etc. Allocation: Normally valued at current market value, often “replacement value.” Note that the buyer may have to pay sales tax on the amount of allocation to this class of assets.
What are examples of risk-weighted assets? ›
What Are Examples of Risk-Weighted Assets? Examples of risk-weighted assets include government bonds and debentures. Banks have different assets that are classified by their risk weight, where lower-risk assets are assigned a lower risk weight.
What is an example of asset and liability risk? ›
For example, if a business has foreign deposits in different currencies, the changes to exchange rates can cause a mismatch between the assets and liabilities. Capital market risk is another example of a type of risk. This happens when there is a change in equity prices.
What are safe vs risky assets? ›
In the financial world “safe” and “risk” reference the potential for you to lose your initial investment. In a safe investment you can expect the possibility of losing what you invested to be low. While you won't likely lose your money in this investment the return on the money you invest will also be low.
Which assets have highest risk factor? ›
Equities and equity-based investments such as mutual funds, index funds and exchange-traded funds (ETFs) are risky, with prices that fluctuate on the open market each day.
