Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Risk-Free Return

What it is:

A risk-free return is the return from an asset that has no risk (that is, it provides a guaranteed return).

How it works (Example):

Treasury bills are the most common example of risk-free assets, and their returns are thus risk-free. Accordingly, these returns are considered the risk-free rate of return. Because the U.S. government has the authority to simply print money, there is virtually no risk that those who lend money to the government (via the purchase of Treasurys) will not receive their interest and principal payments when due.
 

Why it Matters:

The notion of a risk-free return is a fundamental component of the capital asset pricing model, the Black-Scholes option pricing model and modern portfolio theory because it essentially sets the benchmark above which assets that do contain risk should perform. Of course no asset is truly risk-free -- there is always at least some possibility, no matter how minute, that the U.S. government would not be able to repay its debt, for example. But that risk is considered so minute as to be virtually zero.

Regardless of the debate over the true statistical probability of default on risk-free assets, it's important to note that the risk-free return is subject to inflation risk, whereby the returns are eaten away by inflation over time. Also, risk-free returns carry interest-rate risk, meaning that when interest rates rise, the prices of risk-free investments (such as Treasurys) fall, and vice versa.