Risk-free asset

Updated: Aug 20, 2021

An asset which is free of the various possible sources of risk. The risk-free asset is a hypothetical construct that is widely used in finance theory. In practice, it is unlikely that any asset is risk-free unpredictable changes in the economic environment even over the very short term. Many assets promise fixed returns but the real value of this return is uncertain. There is always a risk that the debtor may default; this is thought to be absent in the case of UK, US, and many other countries’ govemment debt. A second risk is that the market price may be low at the time when the asset has to be sold; this risk is high for securities with a long time to maturity, and shrinks steadily as the maturity date gets closer. In money terms, a government obligation is risk-free if the holder has the option to have it redeemed at any time. In real terms, so long as there is uncertainty about inflation no security is risk-free, unless it is suitably indexed. From any individual’s point of view, the suitable index would have weights corresponding to his or her own tastes, and be kept fully up to date. Actual UK government indexed securities use the retail price index with a lag of several months, so are not entirely risk-free in real terms. A third source of risk derives from currency fluctuations. US Treasury bills are usually seen as the closest practical equivalent to a risk-free security, provided that the holder ultimately wishes to purchase commodities denominated in dollars.

Reference: Oxford Press Dictonary of Economics, 5th edt.

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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.