What it means
In theory, a risk-free asset pays a certain return with no chance of loss. In the real world nothing is perfectly safe, so investors use short-term securities issued by strong governments as the closest practical stand-in.
Their short life means little exposure to interest rate swings, and the issuer is very unlikely to fail to pay. The asset matters because every investment decision involves a comparison with it.
If a safe bill pays 4%, then a share must offer a higher expected return to be worth the risk. This gap is called the risk premium, and the safe rate is the starting point for the cost of capital used across corporate finance.
Portfolio theory uses the risk-free asset as a building block. An investor can mix a risky portfolio with the safe asset to dial risk up or down.
Holding more of the safe asset lowers risk and return, while borrowing at the risk-free rate to invest more in the risky portfolio raises both. Businesses also use the idea in their own cash management.
Treasurers park surplus cash in short-term government securities or highly rated money market funds when safety and quick access matter more than yield. The key nuance is that risk-free refers to default risk only.
Inflation can still eat away the real value of the return, and a long-dated government bond can fall in price if interest rates rise, so true safety depends on the horizon and the currency. Over longer periods, investors often prefer inflation-linked government securities as the safe anchor, since they protect the real value of the return.
Which one counts as risk-free depends on the investor's currency, time horizon and what they are trying to protect. There is no single answer for every purpose.
In practice
Real-world examples.
Example
A start-up with $2 million of unspent funding places the money in three-month government bills. The finance lead wants the cash to be safe and available when the next payroll is due.
Example
A financial adviser shows a client how shifting 20% of her retirement savings into government bills reduces the ups and downs of her portfolio. The client accepts a lower expected return for a calmer ride.
Example
A valuation analyst values a private company by starting with the government bill rate as the risk-free rate. She then adds premiums for market risk and for the company's small size.
Formula
Calculation
Return of a mixed portfolio = (Weight in Risk-Free Asset x Risk-Free Return) + (Weight in Risky Portfolio x Risky Return)
Worked example: An investor puts 40% of $500,000 into a government bill paying 4% and 60% into a share portfolio expected to return 10%.
Return = (0.40 x 4%) + (0.60 x 10%) = 1.6% + 6.0% = 7.6%
In dollars: $500,000 x 7.6% = $38,000 expected return.
The safe part provides $200,000 x 4% = $8,000 and the risky part provides $300,000 x 10% = $30,000, and $8,000 + $30,000 = $38,000, which matches.
To see the real return, subtract inflation. If the bill pays 4% and prices are rising at 3%, the approximate real return is 4% - 3% = 1%, so $100,000 grows to $104,000 but buys only about 1% more than before.Case study
Seen in the real world.
Oakhaven Engineering is a fictional firm that received a $3 million advance payment for a project that would not start for nine months. In this illustrative case, the finance manager considered corporate bonds paying slightly more, but chose government bills.
The firm could not afford to lose any of the advance, and the bills matured just before the first supplier payments were due. The extra yield from corporate bonds would have been only about $20,000, which did not justify the risk of a default.
Her decision was recorded in the treasury policy, which now requires any advance payment to be held in government bills or highly rated money market funds until the money is needed. The policy was reviewed annually, and the firm's auditors noted it as a sound control.
Watch out
Common mistakes.
- Believing a risk-free asset has no risk at all. It is free of default risk, but inflation and interest rate changes can still hurt.
- Choosing a long-dated bond as the risk-free asset. Its price can fall sharply if rates rise, so short-term bills are a better stand-in.
- Ignoring currency. A government security is only safe in the currency in which it pays.
Questions
People also ask.
What is the best example of a risk-free asset?
Short-term bills issued by a strong, stable government are the usual choice.
Why do finance models need a risk-free asset?
It sets the baseline return, so the extra return for taking risk can be measured.
Is a bank deposit risk-free?
Not strictly. Deposits may be protected up to a limit by a guarantee scheme, but amounts above that depend on the bank's strength.
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