Published Sep 8, 2024 Risk-free security refers to an investment that is expected to deliver a guaranteed return with no risk of financial loss. In reality, there are very few, if any, truly risk-free assets, but the term is used to describe highly secure investments where the likelihood of default or loss is so minimal that it can be considered negligible. The most commonly cited example of a risk-free security is the U.S. Treasury bond, which is backed by the full faith and credit of the United States government. Consider a 10-year U.S. Treasury bond. When an investor purchases this bond, they are essentially lending money to the U.S. government for a period of 10 years. In return, the government agrees to pay the investor a fixed interest rate on a semi-annual basis and return the principal amount at the end of the 10-year term. Because the U.S. government is considered extremely unlikely to default on its debt obligations, the 10-year Treasury bond is often used as a benchmark for risk-free rates in financial models and economic analyses. This security offers a fixed return over a known period with minimal risk of loss, thereby meeting the criteria of a risk-free security. Other examples of risk-free securities might include government bonds from other stable, developed countries and certain short-term government-issued debt instruments such as Treasury bills (T-bills). Risk-free securities are a fundamental concept in economics and finance for several reasons: In theory, no investment is entirely risk-free. While U.S. Treasury bonds are often cited as risk-free, they still carry minimal risks such as inflation risk (the possibility that inflation will erode the real value of returns) and interest rate risk (the impact of rising interest rates on bond prices). However, the probability of default by the U.S. government on its Treasury securities is so low that these bonds are considered the closest available proxies for a risk-free security. U.S. Treasury bonds are considered risk-free primarily due to the creditworthiness and economic stability of the United States government. The U.S. has a long history of meeting its debt obligations, and the government can raise taxes or print money to avoid defaulting on its debt. This high level of confidence in the government’s ability to honor its commitments makes these bonds the standard for risk-free assets. Government bonds from other stable, developed countries, such as those from Germany or Japan, can also be considered virtually risk-free, albeit not to the same extent as U.S. Treasury bonds. The creditworthiness and stability of the issuing country are key factors in determining whether a government bond can be considered risk-free. Bonds from countries with volatile political or economic environments carry higher risks and are therefore not classified as risk-free. Risk-free securities serve several roles in an investment portfolio. They provide a secure, stable return, which can help balance the higher risks associated with stocks and other more volatile investments. They are particularly useful in constructing a diversified portfolio, adding stability and reducing overall risk. Additionally, risk-free securities are often used as a source of liquidity, as they are usually easy to buy and sell in the market. Alternatives to U.S. Treasury bonds for approximating risk-free returns might include: These alternatives generally offer lower yields compared to riskier investments but are suitable for investors seeking capital preservation and minimal risk.Definition of Risk-Free Security
Example
Why Risk-Free Securities Matter
Frequently Asked Questions (FAQ)
Are there truly any 100% risk-free securities?
Why are U.S. Treasury bonds considered risk-free?
Can other countries’ government bonds be considered risk-free?
How do risk-free securities fit into an investment portfolio?
What are the alternatives to U.S. Treasury bonds for risk-free returns?
Economics