The importance of Risk-free assets

The concept of risk-free assets and risk-free rate of return are central to the modern financial system. They are a key element in many theories of finance, such as capital asset pricing model (CAPM) and black-Scholes option pricing model. According to many academics, there is no such thing as a risk-free asset, as all financial assets carry a certain degree of risk. However, the concept of risks-free assets considers financial assets with very less risk. The level of risk is so low that it can be considered negligible for an average investor. Therefore many intellectuals consider US treasuries or treasuries from stable western governments as risk-free. US treasuries are considered to be risk-free due to several reasons. Firstly, due to their very short maturity, this insulates them from interest-rate risk. Further, the very stable nature of the US government is a key element in their treasuries being considered riskfree assets. The recent US government shutdown led to a wave of uncertainty about the risk freeness of US treasuries. However, some important facts were ignored which led to a rise in the uncertainty. The most important fact is that the US president has emergency powers, which presidents have used in history to force the payment of its debts. Therefore the chances of US government default are negligible. However, due to the recent European crisis the credit worthiness of several sovereign governments is under the spotlight due to their deteriorating fiscal positions. These ongoing credit crises in different parts of the world reflect a new trend in the market for financial assets. This trend consists of diminishing risk-free assets in the financial world. This new trend is dangerous as it suggest that markets are likely to remain volatile and traditional asset-allocation tools are likely to come under scrutiny. This also reflects that the most common strategy of combining high risk assets with risk free assets to create a balance portfolio will become less reliable.