What Is a Risk-Free Asset?
To understand what makes an asset risk-free, let us go back to how risk is measured in investments. Investors who buy assets have returns that they expect to make over the time horizon that they will hold the asset. The actual returns that they make over this holding period may by very different from the expected returns, and this is where the risk comes in. Risk in finance is viewed in terms of the variance in actual returns around the expected return. For an investment to be risk-free in this environment, then, the actual returns should always be equal to the expected return.
To illustrate, consider an investor with a one-year time horizon buying a one-year Treasury bill (or any other default-free one-year bond) ...
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