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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