The risk-free rate of return is one of the most basic components of modern finance. Many of the most well-known financial theories—Capital Asset Pricing Model (CAPM), Modern Portfolio Theory (MPT), and Black-Scholes Model—use the risk-free interest rate as the main component for deriving other valuations. Risk-free assets are only applicable in theory, but their actual safety is rarely questioned until the event goes far beyond the normal daily volatility of the market. Although theories based on risk-free assets are easily questioned, other options are limited.
This article focuses on theoretical and practical risk-free securities (as government securities), and assesses its true risk-free degree. The model assumes that investors are risk-averse and expect a certain rate of return from the excess risk that extends from the intercept, that is, the risk-free rate of return.
Basics of Treasury Bills
The risk-free interest rate is an important part of MPT. As shown in the figure below, the risk-free interest rate is the baseline on which the lowest return can be found with the least risk.
Although risk-free assets under MPT are theoretical, they are usually represented by treasury bills or treasury bills. They have the following characteristics:
- Treasury bills are assumed to have zero default risk because they represent and receive the goodwill support of the US government.
- Treasury bills are sold at auctions during the weekly bidding process and are sold at discounts below face value.
- They do not pay traditional interest like their cousins, Treasury bills and Treasury bonds.
- They are sold in denominations of $1,000 in various terms.
- Individuals can buy directly from the government.
Since the options for replacing U.S. Treasury bills are limited, it helps to understand other areas of risk that may have an indirect impact on the risk-free assumption.
Source of risk
The term risk is usually used very loosely, especially when it comes to risk-free interest rates. At the most basic level, risk is the probability of an event or result. When applied to investment, risk can be decomposed in several ways:
- Absolute risk defined by volatility: The absolute risk defined by volatility can be easily quantified by common indicators such as standard deviation. Since risk-free assets usually mature in three months or less, volatility indicators are inherently very short-term. Although daily prices related to yield can be used to measure volatility, they are not commonly used.
- Relative risk: When applied to investment, relative risk is usually expressed by the relationship between asset price fluctuations and the index or basis. An important difference is that relative risk hardly tells us absolute risk-it only defines the degree of risk of the asset compared to the foundation. Similarly, because the risk-free assets used in the theory are so short-term, relative risk does not always apply.
- Default Risk: What are the risks when investing in three-month treasury bills? The risk of default, in this case, is the risk of the US government defaulting on its debt. Credit risk assessment measures deployed by securities analysts and lenders can help determine the ultimate risk of default.
Although the US government has never defaulted on any debts, the risk of default has increased during extreme economic events. The US government can promise the ultimate security of its debt in many ways, but the reality is that the US dollar is no longer backed by gold, so the only real security of its debt is the government’s ability to generate revenue from its current balance or tax revenue.
This raises many questions about the reality of risk-free assets. For example, suppose that the economic environment has a huge deficit funded by debt, and the current government plans to cut taxes and provide tax incentives to individuals and companies to stimulate economic growth. If the plan is used by a listed company, if the plan is basically to reduce revenue and increase expenditure, how can the company justify its credit quality?
This is the problem: there is really no reason or alternative to risk-free assets. Other options have been tried, but U.S. Treasury bills are still the best choice because it is the investment closest to short-term risk-free securities—in theory and in reality.