Risk-Free Asset is an investment with a guaranteed rate of return meaning principal does not decline in value, and therefore it has no volatility. An example is a Treasury Bill. The addition of the risk-free asset to Modern Portfolo Theory brought on Capital Market Theory because it offered investors a choice between the risk-free asset and the Market Portfolio of risky assets.
Synonyms: risk-free return, risk-free investment, risk-free rate
Doc: When the Fed lowers rates, and the
risk-free asset , it
hopes to boost the economy.
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Risk-free asset definition for investment modeling (4:38)
The script includes two sections where we visualize and demonstrate the concept of the risk-free asset.
We're sitting in Excel and this is a snippet from our boot camp course.
There we cover all of the curves, lines and dots shown here in one 40-minute video, but because most people can't sit still that long, we break it out into eleven separate 4-5 minute videos, just like this one. I'll provide a link to the boot camp video at the end if you'd like the whole story. (See the updated tutorial Ace Your Portfolio Theory Exam instead).
Ok, let's focus on the risk-free asset, also known as the risk-free rate, which is part of Capital Market Theory, developed in the 1960s.
First of all, we have a chart, with expected return on the y-axis and expected risk on the x-axis. Here we are using the expected timeframe, which uses historical data as input and then you run a regression to calculate what is baked-in to market expectations. This is the expected timeframe. Setting expectations like this is a focus of the boot camp.
Now, the risk-free asset, marked rf1 or rf2 here, is a positive figure on the return or y-axis, and zero on the risk, or x-axis.
The curves and dots on the right represent advancements in Modern Portfolio Theory for risky assets, meaning, positive risk and we cover those topics elsewhere, but the point of the risk-free asset is that it sits over here and any investor can choose to invest exclusively in a risk-free asset.
Of course this is a theoretical concept, and for academic theories to work, scholars must include a list of assumptions, meaning holding other variables constant. And here is a list of MPT assumptions to review later.
Let's now demonstrate this by talking about two points. First, at rf2 an investor invests 100% in Treasury Bills. The second point here at M2, which represents 100% in the Market Portfolio, which in theory is a diversified basket of all risky assets globally.
As mentioned, the risk-free asset advanced portfolio theory because it demonstrated how investors could choose between, or allocate to, these two assets exclusively. Think about it this way, the investor seeking a higher return must take risk, and move up this line, called the Capital Market Line, by adding risky assets. At the midpoint the investor might have 50% in T-Bills and 50% in the Market Portfolio. This concept introduced the terms asset allocation, which you've likely heard before, and the less popular term, the separation property.
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