Risk-Free Asset

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 INTRODUCTION OF THE RISK-FREE ASSET:

The first assumption of capital market theory listed above is that investors can borrow and lend at the risk-free rate. Although the introduction of a risk-free asset appears to be a simple step to take in the evolution of portfolio and capital market theory, it is a very significant step. In fact, it is the introduction of a risk-free asset that allows us to develop capital market theory from portfolio theory. 

With the introduction of a risk-free asset, investors can now invest part of their wealth in this asset and the remainder in any of the risky portfolios in the Markowitz efficient set. This allows Markowitz portfolio theory to be extended in such a way that the efficient frontier is completely changed, which in turn leads to a general theory for pricing assets under uncertainty. 



Defining a Risk-Free Asset:

An asset which an indubitable return is a risk-free asset. This type of asset has a definite future return, regardless of what the risk of the assets are. An asset with a certain return that gives an investor a level of assurance over the asset can be regarded as a risk-free asset.

 A risk-free asset can be defined as one with a certain-to-be-earned expected return and a variance of return of zero. (Note, however, that this is a nominal return and not a real return, which is uncertain because inflation is uncertain.) Since variance = 0, the nominal risk-free rate in each period will be equal to its expected value. Furthermore, the covariance between the risk-free asset and any risky asset i will be zero.

The true risk-free asset is best thought of as a Treasury security, which has little or no practical risk of default, with a maturity matching the holding period of the investor. In this case, the amount of money to be received at the end of the holding period is known with certainty at the beginning of the period. The Treasury bill  typically is taken to be the risk-free asset, and its rate of return is referred to here as RF.

How Does a Risk-Free Asset Work?

Treasury bills are the most common example of risk-free assets. Because the U.S. government has the authority to simply print money, there is virtually no risk that those who lend money to the government (via the purchase of Treasury's) will not receive their interest and principal payments when due.

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