Is The Risk-Free Rate Truly Risk-Free?

“Risk” is a something of a loaded word, having a somewhat negative implication. Most people only focus on the downside risk, and when we hear about “risky” investments it is typically in reference to penny stocks, cryptocurrencies, and other speculative instruments. The accepted meaning of “risk” in financial jargon, however, is typically to convey standard deviation, which encompasses both potential underperformance and outperformance relative to a mean expectation for investment return. After all, risk can lead to both losses and gains, otherwise no reasonable investor would ever take on any risk.

If you are even casually familiar with the Capital Asset Pricing Model (CAPM), you’ve heard the term “risk-free rate”. The risk-free rate (RFR) is a theoretical measure of an investment with zero risk, over a specified period. Typically, the 3-month Treasury Bill (T-Bill) is used to represent the RFR, given the near-zero probability of the US government defaulting on its short-term debt. The 3-month T-Bill currently stands around 4.8%, the highest yield since 2007. Earning an annualized 4.8% with zero risk certainly seems enticing, and investors have taken note, funneling cash into money market funds which now hold a record $5.2 Trillion in investor deposits.