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Abstract
Determining the price of a financial instrument is something that happens every day in the financial markets. Every price starts off with a spot price adjusted for interest until maturity of the particular instrument. The interest is usually described as risk-free interest. The price so determined is the most basic price that an investor is willing to pay if not risk is involved. Risk-free assets, then, are securities of which the future rates of return are known with certainty. An exceptional degree of confidence in the issuer of the security brings about this certainty. Risk-free assets are normally in the fixed income securities (capital markets) investment category or in the liquid money market instruments such as treasury bills, category. This study attempts to determine whether the risk-free rates used by treasury managers and traders in South Africa to formulate their bond yield curves and which are used in valuation models, may be deemed risk-free. The study specifies certain criteria that an asset must satisfy in order to be used as a risk-free asset. Short term and long term South African instruments are compared to the US counterpart instruments, to gain an understanding of the South African instruments relative to the US ones. The behaviour of the risk-free instruments used in South Africa is also compared to the FTSE/JSE All Share Index and gold spot prices, which are perceived to be a risky asset classes.
To gain some understanding of the behaviour of these instruments, analyses were done from different angles. The standard deviations of the daily percentage changes of the R157 were significantly lower than that of the ALSI and the gold spot price change. Compared to the ALSI and gold spot price, therefore, the R157 may be deemed a “low risk” instrument. The JIBAR was even less volatile that the R157. Interestingly, the US instruments were substantially more risky than the SA instruments over the analysis period. Also the JIBAR may be labelled “low risk” in this context. To improve on the comparisons especially where the magnitudes of change and the bases were very different, indices were used to compare the different instruments. Based on the index change, the JIBAR was now more risky than the R157. The ALSI and the gold spot was sill substantially more volatile than the JIBAR and R157. On this basis, the US instruments appeared less volatile but still more volatile than the SA instruments. It may be noted that the volatility of the US instruments were greatly influenced by the recent financial crisis.
Keywords: Risk-Free, Risky, Low Risk Assets, Volatility, Correlation
How to cite this paper: Oosthuizen, A.V., & Van Rooyen, J.H. (2013). Risk-free assets: Are they truly risk-free? A comparative study of South African rates and instruments. Risk governance & control: financial markets & institutions, 3(3-1), 127-148. https://doi.org/10.22495/rgcv3i3c1art5
FAQs
No investment is truly risk-free
The notion of risk does not necessarily have the same definition for everyone. While some savers fear above all the loss of purchasing power of their capital, others will see the risk more in the immobilisation of their assets or in the reliability of their financial intermediary.
What is the correlation between a risky asset and a risk-free asset? ›
The book then says since “the variance of the risk-free asset is zero” and “the correlation between the risk-free asset and any risky asset, M, is also zero” the formula can be restated in the form of Equation (9).
What is the difference between a risky asset and a risk-free asset? ›
The simplest way to examine this is to consider a portfolio consisting of 2 assets: a risk-free asset that has a low rate of return but no risk, and a risky asset that has a higher expected return for a higher risk.
What is 100% risk-free? ›
Risk free rate is the ideal return on investment with no risk. Investors only take risks if the potential return is higher than the risk-free rate. In reality, no investment is entirely risk-free, they all have some level of risk.
Is risk-free rate real? ›
In practice, this rate of return doesn't truly exist: every investment carries some amount of risk, even if that risk is small. The three-month U.S. Treasury bill is often used as a proxy for a risk-free rate of return in U.S. markets because the risk of default by the government is low.
What is the safest asset on earth? ›
Treasury Bills, Notes and Bonds
U.S. Treasury securities are considered to be about the safest investments on earth. That's because they are backed by the full faith and credit of the U.S. government. Government bonds offer fixed terms and fixed interest rates.
What are the safest assets to own? ›
Safe assets are those that allow investors to preserve capital without a high risk of potential losses. Such assets include treasuries, CDs, money market funds, and annuities. There is, of course, a risk-return tradeoff, such that safer assets typically offer comparatively lower expected returns.
Which asset is riskiest of all? ›
Equities are generally considered the riskiest class of assets. Dividends aside, they offer no guarantees, and investors' money is subject to the successes and failures of private businesses in a fiercely competitive marketplace. Equity investing involves buying stock in a private company or group of companies.
Can you combine risky and risk-free assets? ›
By combining a portfolio of risky assets with a risk-free asset, we can improve the return-risk characteristics of the portfolio and realize a better trade-off.
Is cash a risk-free asset? ›
Even cash, as mentioned, carries the risk of losing value because of inflation, and it's also possible that inflation will outpace your investments in Treasurys.
Risk-free assets will provide the investor with capital that is relatively more liquid and less likely to fluctuate in value over time. The riskier asset is more prone to greater changes in value in both the positive and negative direction.
What is the most risk-free asset? ›
Debt obligations issued by the U.S. Department of the Treasury (bonds, notes, and especially Treasury bills) are considered to be risk-free because the "full faith and credit" of the U.S. government backs them. Because they are so safe, the return on risk-free assets is very close to the current interest rate.
What is the risk-free rate of a risk-free asset? ›
The Risk Free Rate (rf) is the theoretical rate of return received on zero-risk assets, which serves as the minimum return required on riskier investments. The risk-free rate should reflect the yield to maturity (YTM) on default-free government bonds of equivalent maturity as the duration of the projected cash flows.
Do risk-free assets have volatility? ›
Risk-free assets provide a safe harbor against market volatility, but that safety comes at a cost.
Is it possible to build a risk-free portfolio using risky assets? ›
An equivalent portfolio is understood to be a portfolio made up of two risky assets that, on average, generate the same return as a risk-free asset. This new portfolio has zero risk and a Beta equal to 0.
Can risk-free be negative? ›
The correct interpretation is that the risk-free rate could be either positive or negative and in practice the sign of the expected risk-free rate is an institutional convention – this is analogous to the argument that Tobin makes on page 17 of his book Money, Credit and Capital.
What is the risk-free rate of an asset? ›
The Risk Free Rate (rf) is the theoretical rate of return received on zero-risk assets, which serves as the minimum return required on riskier investments. The risk-free rate should reflect the yield to maturity (YTM) on default-free government bonds of equivalent maturity as the duration of the projected cash flows.
, Johan H. Van Rooyen
