Risk-Free Asset Definition, Tutorial and Quiz for Financial Modeling

Understanding the Risk-Free Asset (Risk-Free Rate)

Intermediate

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 U.S. 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

For context, examples of risk-free assets include the following.

Bank Checking and Savings Accounts - up to the insured value
Guaranteed Investment Contracts (GICs) - from insurance companies
U.S. Treasury Bills - due to their discounted purchase price
Money Market Mutual Funds - as long as sponsors support the funds so so they don't 'break the buck'.

Recall that no asset is truly risk-free; however, certain assets by their structure are close enough that scholars felt comfortable using the term Risk-Free Asset.

In a Sentence

Doc: When the Fed lowers rates, or the yield on the risk-free asset, it hopes to boost the economy.
Lia: Is this another Fed action that helps the rich get richer?

Video

This video can be accessed in a new window or App , at the YouTube Channel or from below.

Risk-Free Asset definition for investment modeling (4:38)

Video Script

The script includes two sections where we visualize and demonstrate the concept of the risk-free asset.

Visualize

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.

Demonstrate

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.

Quiz

Click box for answer.

The addition of the risk-free-asset with Capital Market Theory provided academic buy-in for the concept of asset allocation. | True or False?

True

Low and negative interest rates act to steepen the reward-to-risk ratio and this gives investors more incentive to take risk. | True or False?

True. This is the logic for monetary policy by central bankers.

Questions or Comments?

Still unclear on the Risk-Free Asset? Leave a question in the comments section on YouTube or check out the Quant 101 series.

Related Terms

Our trained humans found other terms in the category Capital Market Theory you may find helpful.

Risk-Free Asset Definition, Tutorial and Quiz