Risk-Free Asset - Explained
What is a Risk-Free Asset?
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Table of ContentsWhat is a Risk-Free Asset?How Does a Risk-Free Asset Work?Understanding RiskReinvestment Risk
What is 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 good example of a risk-free asset of the United States Treasury Bills, these assets are largely risk-free and there is a guarantee of a return. Despite that all assets or investments have a degree of risks, risk-free assets are known for their reliable future return. These assets are often considered safe for investors.
How Does a Risk-Free Asset Work?
The future return on a risk-free asset is certain. There is however an argument by some academics that the concept of risk-free asset does not exist, given that there is no asset without risks. It is important to know that risk-free assets are not totally risk-free but that the level of risk they have is so insignificant that it is inappropriate to call it a risk which is what gave rise to the concept of risk-free assets.
Oftentimes, the expected return on an investment may differ from the actual return on the investment. This is due to the period for which the asset is held and factors like market fluctuations, decline in interest rates and losses recorded in the investment. For an average investor, a risk-free asset is quite attractive because it has a certain future return and minimal level of risk. The return on risk-free asset is however not as high as other types of assets, this is because the return of the asset reflect the level of risk involved. A lower return signifies a lower risk while higher return indicates higher risk.
Reinvestment is a major feature of most types of investments, assets that are risk-free also have reinvestment option. Reinvestment risk can ensue due to the fact that a risk-free asset might have an initial rate of return different from the reinvestment rate of return. It is however argued that for a long-term asset to be described as risk-free, it must attract no risk when reinvestment. For many long-term assets, there is a level of risk that they attract makes it difficult for them to be called risk-free assets.