The Riskfree Asset

By virtue of its power to tax and control the money supply, only the government can issue default-free bonds. Even the default-free guarantee by itself is not sufficient to make the bonds risk-free in real terms. The only risk-free asset in real terms would be a perfectly price-indexed bond. Moreover, a default-free perfectly indexed bond offers a guaranteed real rate to an investor only if the maturity of the bond is identical to the investor's desired holding period. Even indexed bonds are subject to interest rate risk, because real interest rates change unpredictably through time. When future real rates are uncertain, so is the future price of indexed bonds.

Nevertheless, it is common practice to view Treasury bills as "the" risk-free asset. Their short-term nature makes their values insensitive to interest rate fluctuations. Indeed, an investor can lock in a short-term nominal return by buying a bill and holding it to maturity. Moreover, inflation uncertainty over the course of a few weeks, or even months, is negligible compared with the uncertainty of stock market returns.

In practice, most investors use a broader range of money market instruments as a risk-free asset. All the money market instruments are virtually free of interest rate risk because of their short maturities and are fairly safe in terms of default or credit risk.

Most money market funds hold, for the most part, three types of securities—Treasury bills, bank certificates of deposit (CDs), and commercial paper (CP)—differing slightly in their default risk. The yields to maturity on CDs and CP for identical maturity, for example, are always somewhat higher than those of T-bills. The pattern of this yield spread for 90-day CDs is shown in Figure 7.1.

Money market funds have changed their relative holdings of these securities over time but, by and large, T-bills make up only about 15% of their portfolios. Nevertheless, the risk of such blue-chip short-term investments as CDs and CP is minuscule compared with that of most other assets such as long-term corporate bonds, common stocks, or real estate. Hence we treat money market funds as the most easily accessible risk-free asset for most investors.

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