Corpfin Pedagogy: Are T-Bills Really Risk-Free?

When teaching the fundamentals of risk and return in the introductory Corpfin course, I like to ask the following question at some point in the discussion: "Does a "risk-free" asset really exist?

Generally, two things happen. One group of students will answer "Of course." Another (generally smaller) group will answer "No way." This is the basis of a discussion!

If you can get students to ponder the question further, you'll find that many doors will open. First of all, of course, which group is right? And if one assumes that a reasonable proxy does exist, what is it? Finally, what is the current risk-free rate?

With respect to the first question, I begin by telling the class that a truly riskless asset doesn't exist in reality -- there is a nonzero (if small) possibility that the U.S. Treasury could default (in a meaningful fashion) on its obligations at some point.

The second question gives you the opportunity to discuss the attributes a true risk-free asset would have, then tick off possible proxies (savings accounts, Treasury bills, notes, bonds) and discuss their suitability vis-a-vis the attributes you have just discussed.

The result of the above discussion is generally that T-bills are a reasonable (though not universally accepted) proxy. But what if one considers variability of real return? In that case, even (realized) T-bill returns don't appear quite so stable. Consider the graphic below, which appeared in the November 3, 1997 issue of Forbes magazine in a column entitled "Why T bills can be risky."

As you can see, between 1980 and the present, the real T-bill yield has ranged from about -4% to as high as about 7%, with more recent values fluctuating around 2%. In any event, it is clear that the real return has been volatile over the last two decades - a point to keep in mind when one blithely refers to T-bills as a riskless asset!

Finally, what is the riskfree rate? Here's a good chance to bring The Wall Street Journal into the discussion. Go to the "Credit Markets" section, find the "T-bills" column, and ask the students to determine which rate is "the" risk-free rate. Of course, the answer is "All of them." Nonetheless, the exercise provides an opportunity for you to bring the real world into the classroom, and, if time allows, expand on the yield curve, etc.

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