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What is a risk-free asset?
A risk-free asset comes with a virtually guaranteed return. Usually, all investments have a degree of risk associated with them, so the term "risk-free" is used to mean the assets that are sufficiently safe so that investors can remain sure to get a return on their investment that is somehow close to the return predicted for the asset while investing.
A risk-free asset has a definite future return, whatever the risk of the assets is. This type of asset often provides a certain return providing investors a level of assurance over the return from the.
The United States Treasury Bills are a good example of risk-free assets. These assets are usually completely risk-free and there is a certain guarantee of a return from the investment. Although all assets or investments have a certain degree of risks, risk-free assets are considered safer for expected future returns. Risk-free assets are usually considered safe for investors, although the returns are low.
Note − Risk-free assets are not completely risk free, but the risk associated with them is insignificant.
More about a Risk-Free Asset
The expected future return on a risk-free asset is usually almost certain. However, some academics do not agree with the concept of risk-free assets, as there is no investment with zero risks.
The point to note here is that risk-free assets are not 100% risk-free but the level of risk associated with them is so insignificant that it will be inappropriate to call them risky. This is where the rise to the concept of risk-free assets starts.
Return on Risk-Free Asset
Most often the expected ROIs may differ from the actual returns. This occurs due to the holding period of the assets, the decline in interest rates, market fluctuations, and losses that occur in the investment. For an investor who doesn’t seek high returns, a risk-free asset is often a good choice because it has a guaranteed future return and minimum level of risk. The return on risk-free assets is lower than other types of assets because the returns reflect the level of risk involved in security. A lower return shows a lower risk, while a higher return confirms a higher risk.
Reinvestment Risk
Reinvestment is a notable feature of almost all types of investments; Risk free assets can also be reinvested. A risk-free asset may have an initial rate of return that is different from the reinvestment rate of return.
For a long-term asset to be described as risk-free, it should not attract any risk when reinvested. For many types of long-term assets, there is kind of a level of risk that they attract which makes it difficult for them to call risk-free.
Note − An asset that is risk-free on initial investment may become risky while reinvested.
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