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“RISK-FREE ASSET”-ALL YOU NEED TO KNOW-COMPILED BY ER. AVINASH KULKARNI

Saturday Brain Storming Thought (129) 04/09/2021

COMPILED BY ER. AVINASH KULKARNI

RISK-FREE ASSET

A risk-free asset is one that has a certain future return and virtually no possibility of loss

These assets are often considered safe for investors

Key points for the risk-free asset

1) certain future returns

2) virtually no possibility of loss

3) tend to have a low rate of return

4) guaranteed against nominal loss, but not against a loss in purchasing power

5) over the long-term, risk-free assets may also be subject to reinvestment risk

Risk-free assets include following

1) bank checking and saving accounts – up to the insured value

2) guaranteed investment contracts (GICs) – from insurance companies

3) government treasury bills – due to their discounted purchase price

4) money market mutual funds – as long as sponsors support the funds so they don’t break the buck

5) fixed deposits (FD)

6) Recurring deposits (RD)

7) Public Provident Fund (PPF)

8) Post office saving schemes

Gold is a risk-free asset but not a risk-free investment

Cash is a risky asset

There is no such thing as a truly risk-free asset for long-term investors

Understanding Risk

Expected return on investment may differ from the actual return on the investment

Lower return – lower risk
Higher return – higher risk

Types of Risks

1) business risk – companies undertake high-cost risks in Marketing to launch a new product in order to gain higher sales

2) Non-business risk – these risks arise out of political and economic imbalances

3) Financial risk – financial loss to the firm, generally arises due to instability and losses in the financial market caused by movements in stock prices, currencies, interest rates, and more

Financial Risks

1) Market Risk
Absolute, relative, directional, non-directional, basis & volatility risk

2) Credit Risk
It arises when one fails to fulfill their obligations towards their counterparties – credit event, sovereign & settlement risk

3) Liquidity Risk
Arises out of an inability to execute transactions either due to insufficient buyers or insufficient sellers against sell orders and buy orders respectively – asset & funding liquidity risk

4) Operational Risk
Arises out of operational failures such as mismanagement or technical failures – fraud and model risk

5) Legal Risk
Arises out of legal constraints such as lawsuits – a company needs to face financial losses out of legal proceedings

The standard deviation of a risk-free asset

Risk-free asset has the same return in all states of the world

This the variance (and standard deviation) of the risk-free return is zero since the expected return and possible returns are the same in all states of the world

Correlation between risk-free and risky asset

Relationship between the risk-free and risky asset are always linear

The covariance and correlation of the risk-free and risky asset or portfolio will always equal zero

Risk Assets

1) equities

2) commodities

3) high-yield bonds

4) real estate

5) currencies

Low-risk investments

1) treasury notes, bills, and bonds

2) corporate bonds

3) money market mutual funds

4) fixed annuities

5) preferred stocks

6) common stocks that pay dividends

7) index funds

Asset Risk

The measure of an assets default potential or market value fluctuations

The time horizon for risk-free asset

It should consider the time frame of the investment – 3 to 10 years depending upon risk reference

Risk-free Rate

1) risk-free rate is a rate of return of an investment with zero risk
2) it is the hypothetical rate of return

3) securities backed by the government

A risk-free asset means an asset whose future return is known today with certainty

Sharpe Ratio

It is the measure of risk-adjusted Return Of a financial portfolio

Normally, the 90-day treasury bill rate is taken as a proxy for the risk-free rate

Risk-free asset requirements

1) no default risk

2) actual return equal to the expected return

3) no reinvestment risk

4) risk-free rate for a 5-year time horizon has to be expected

An asset with no depreciation from a valuation point of view

You can’t depreciate property for personal use, inventory, or assets held for investment purpose

You can’t depreciate assets that do not loose their value over time or that you are not currently making use of to produce income

1) land

2) collectibles like art, coins or memorabilia

3) investment like stocks and bonds

4) building that you are not actively renting for income

5) personal property, which includes clothing and your personal residence and car

6) any property placed in service and used for less than one year

Compiled by:-

Er. Avinash Kulkarni

Chartered Engineer
Govt Regd Valuer
IBBI Regd Valuer

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