This question came up during my conversation with my Uncle. Generally, we say that investors expect to be compensated for the risk we take. So, if the asset is risk-free, then our return should be, theoretically, zero. Correct? What’s wrong with this rationale? Any help?
Moreover, this page (https://en.wikipedia.org/wiki/Risk-free_interest_rate) does talk about different interpretations for “risk-free”, I am not sure what CFA curriculum means by “risk-free.” So, I thought of asking this question. I’d appreciate any thoughts.
At the very least, you should earn the expected rate of inflation, not zero.
Thanks S2000magician. However, if that’s true, why do we use T-bills as risk-free asset (and not inflation) in portfolio theory. I am assuming that T-Bill’s rate of return < rate of inflation. For instance, currently 1-year Treasury rates are < 0.8% (https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield) but inflation is about 1.1% (http://www.usinflationcalculator.com/inflation/current-inflation-rates/).
I’d appreciate your thoughts and thanks in advance.
In the real world, there is no true risk-free asset. The best approximation we can achieve is to use an asset with a time horizon close to our investment horizon, which is essentially default-free: hence, government bonds. Realize that it’s just an approximation, and don’t dwell on the minor inconsistencies.