The risk-free rate of return is one of the most basic components of modern finance. The risk-free asset only applies in theory, but its actual safety rarely comes into question until events fall far beyond the normal daily volatile markets. Although it's easy to take shots at theories that use a risk-free asset as their base, there are limited other options.

This article looks at theoretical and realistic risk-free financial securities in theory and evaluates how risk-free it truly is. The model assumes that investors are risk av🔯erse and will expect a certain rate o🐻f return for excess risk extending from the intercept, which is the risk-free rate of return.

The T-Bill Base

The risk-free rate of return is an important building block for 澳洲幸运5官方开奖结果体彩网:modern portfolio theory (MPT). As referenced in the figure below, the risk-free rate is the baseline where the lowest returಌn can be found with the least amount of risk.

Risk-free assets under MPT, while theoretical, typically are represented by Treasury bills (T-bills), which have the following characteristics:

• T-bills are assumed to have zero 澳洲幸运5官方开奖结果体彩网:default risk because they represent and are backed by the good faith of the U.S. government.
• T-bills are sold at auction in a weekly competitive bidding process and are sold at a discount from par.
• They don't pay traditional interest payments like their cousins; 澳洲幸运5官方开奖结果体彩网:Treasury notes and 澳洲幸运5官方开奖结果体彩网:Treasury bonds.
• They're sold in various maturities in denominations of $100 up to $10,000,000 (non-competitive bid).
• They can be purchased by individuals directly from the government.
  

Because there are limited options to use instead of the U.S. T-bill, it helps to have a grasp of other areas of risk that can have indirect effects onꦦ risk-free assumptions.

Sources of Risk

The term risk is often used very loosely, especially when it comes to the risk-free rate. At its most basic level, risk is the probability of e🅺vents or outcomes. When applied to investments, risk ca🦹n be broken down in different ways:

• Absolute Risk as Defined by Volatility: Absolute risk as defined by volatility can be easily quantified by common measures like standard deviation. Since risk-free assets typically mature in three months or less, the volatility measure is very short-term in nature. While daily prices relating to yield can be used to 澳洲幸运5官方开奖结果体彩网:measure volatility, they are not commonly used.
• Relative Risk: Relative risk, when applied to investments, is usually represented by the relation of price fluctuation of an asset to an index or base. One important differentiation is that relative risk tells us very little about absolute risk—it only defines how risky the asset is compared to a base. Again, since the risk-free asset used in the theories is so short-term, relative risk does not always apply.
• Default Risk: What risk is assumed when investing in the three-month T-bill? 澳洲幸运5官方开奖结果体彩网:Default risk, which, in this case, is the risk that the U.S. government would default on its debt obligations. 澳洲幸运5官方开奖结果体彩网:Credit risk evaluation measures deployed by securities analysts and lenders can help define the ultimate risk of default. 

Reality of a Risk-Free Asset

Although the U.S. government has never defaulted on any of its debt obligations, the risk of default has been raised during extreme economic events. The U.S. government can promise the ultimate security of its debt in numerous ways, but the reality is that the U.S. dollar is no longer backed by gold, so the only true security for its debt is the government's ability to make payments from current balances or 澳洲幸运5官方开奖结果体彩网:tax revenues.

This raises many questions about the reality of a risk-free asset. For example, say the economic environment is such that there is a large deficit being funded by debt, and the current administration plans to reduce taxeꦦs and provide tax incentives to both individuals and companies to spur economic growth. If this plan were used by a publicly held company, how could the company justify its credit quality if the plan were to decrease revenue and increase spending?

That is the rub: There is no justification or alternative for the risk-free asset. There hav🔴e been attempts to use other options, b🐷ut the U.S. T-bill remains the best option because it is the closest investment—in theory and reality—to a short-term risk-less security.

The Bottom Line

U.S. Treasuries are considered to🐭 come with a risk-free rate because they are backed by the full faith of the U.S. government, which is a nation with a strong economy and political stability, where the likelihood of default is pretty much zero. Investors seeking safety in investments during volatile markets could do well with U.S. Treasuries.