Most assets in our world are risky: Their future payoffs can take many different values, some of them (very) high, others (very) low. Think about stocks. If you invest in, say, Amazon shares today, you might have a target price in mind for the next year. However, the actual price in a year may be very different than what you expected (in a good or bad way). The same goes for assets other than stocks as well. For example, when you buy a house, you have no certainty about the price you can sell it for in the future. The house may even lose value. This is also true for other risky assets such as corporate bonds, derivatives, (crypto) currencies, and so on.
The question is, if you don’t like that uncertainty and simply want a sure return, how can you achieve that as an investor?
- Define the concepts of a riskless asset and risk-free rate of return.
- Evaluate the suitability of different asset classes for being a risk-free asset.
The concept of a risk-free asset
We can easily illustrate the distinction between a risky asset and a riskless one. Suppose you invest £1,000 in an asset. If there is any uncertainty about the future payoffs of that asset, it should be considered as a risky asset. For example, if the asset pays back £1,200 with 60% probability and £750 with 40% probability, the asset is risky. You know that you’ll get back either £1,200 (+20% return) or £750 (-25% return). But, you don’t exactly know which of the two payoffs you’ll get, hence the risk. In contrast, if the asset guarantees to pay back £1,100, then there is no uncertainty, the asset is riskless, and the risk-free rate of return is:
£1,100 / £1,000 — 1 = 10%
Which assets can be considered risk-free?
So, which assets fit the definition of a risk-free asset? Does a risk-free asset exist at all? The examples we gave at the beginning of the post suggest that stocks, corporate bonds, derivatives, real estate, (crypto) currencies do not fit the definition due to the uncertainty in their future payoffs. We don’t know future stock prices, corporate bonds carry default risk, and so on.
Academics and practitioners often focus on government bonds as the best candidate for risk-free assets. However, there are some caveats as we discuss next. Why government bonds can be considered risk-free or at least almost risk-free? The answer is that if governments face difficulty meeting the payments promised by their bonds (i.e., serving their debt), they can raise taxes or even print/inject money to meet their debt obligations. Corporations have no such power. So, if they fall into financial distress, they might be forced to default on their bonds. Therefore, corporate bonds carry default risk (to varying degrees as rated by credit agencies). As a result, they can’t be considered risk-free.
Caveats of treating governments bond as risk-free
The problem here is that there is a limit to the amount of tax governments can raise and/or the amount of money they can print (before the inflation gets out of hand). Consequently, governments can be forced to default on their debt in the same way as corporations. In fact, there are multiple examples whereby a government either defaulted or came very close to defaulting on their debt (e.g., the Russian debt crisis in 1998, the Greek debt crisis following the financial crisis of 2007/2008). So, credit agencies rate debt issued by governments as well as corporations. However, given governments’ powers to raise taxes and print/inject money (you might have heard the associated term “quantitative easing”), government debt can be considered safer than corporate debt. And, if the government in focus has strong finances, we can treat its debt as riskless.
In summary, the risk-free rate of return is earned on a riskless asset. And, investors know the future payoff of their investment in a riskless asset with certainty. In practice, yields on treasury bills, notes, and bonds issued by governments are taken as the risk-free rate of return as governments have certain powers to avoid default on their debt. However, these powers are not limitless, and there are instances of sovereign defaults in history.
What is next?
This post is part of our free course on investments. The previous post in the series explained how to calculate the expected return on a risky asset. In the next post, we will discuss how we can make a distinction between investors in terms of their appetite for risk.
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