In: Finance
Is it true that a US Treasury security is risk-free?
Solution: | |||
No, US Treasury security is not risk-free | |||
US Treasury security is type of bonds, notes, bills issued by Federal government , Some pays Coupon & some are issued at heavy discount. And as we know bonds value changes with changes in interest rates that apply to US Treasury security also, US Treasury security value changes with changes in interest rates. | |||
And interest changes with changes is macro of the economy, Specially long term Treasury security are more risky as in long run we cannot evaluate economy condition , so we are taking higher risk on long term US Treasury Securities. | |||
As US Treasury security is backed by Federal government it is risk free from default of payments under the terms of issue of US Treasury security given. | |||
Hence, we can say US Treasury security is not totally risk-free | |||
Please feel free to ask if anything about above solution in comment section of the question. |
I think, I should begin with what is a treasury Security? Or what is a US treasury security?.
It is simply something or a security or any bond or say any contract whereby the Federal Government raises money from the people buying these securities. Now a full fledged government of a country is most trust-worthy entity in the whole country. So more is the trust worthiness lesser is the risk and hence is the return on that security.
Now, what might be the risks associated once you buy the security from anyone. There can be a default risk, inflation risk, current credit risk, potential credit risk and many more.
First we see the default risk which is actually 0, as you know Federal Government is not going to default from its promised return. Then we come to infaltion risk which is NOT ZERO. This is the only risk present in treasury securities and hence the return on treasury bills is little more than those from the savings bank accounts. Now credit risk is virtually zero, as we define credit risk as risk associated with getting the invested principal and return on it on desired/ pre-determined time. Now here it's expected that government would be providing you with both the principal and the return on time or may be a while later or so. Hence, its considered to be tending to zero.
So, now what can we say is that, there is inflation risk in treasury security and no other risk, So we can say that US treasury security is not risk-free. Although this is the security with least risk hence to consider a benchmark rate of return with least risk we take it as risk-free security for other purposes.
Note: we can't use savings bank interest rate as risk free security rate because that is not about purchasing a security or any financial entity from an issuer, so that would be logically incorrect and so we use treasury rates as risk-free rates.