Risk-free Investment Model

Risk-free Investment 

Suppose there is no risk or a problem that needs to be faced. By claiming that there is no risk, one can assume that if an amount is invested in order to receive a stream of benefits in the future, all those future benefits are certain to arrive. This is problematic because the purpose of the analysis is basically to enable us to distinguish among projects. If the world were to entail no risk, this must mean that all the future cash flows would be known with certainty. Then so far, no investment opportunity could be any better or worse than any other.

Risk-free Investment Model

Suppose for instance that the prevailing rate of interest were 12%. Now suppose an investor wished to invest in a new machine. The price of the machine would be fixed in the market. Since the future cash flows that the machine could generate would be certain, then both buyers and sellers of such machines would be aware of these returns. Buyers would be prepared to pay any price up to that which would bring the returns down to 12%. At any higher price they would not buy, since other opportunities would be available to them giving this return. Sellers similarly would not price the machines any lower since buyers would be willing to pay that price which led to a 12% return.

Thus any asset in a world of risk-free markets would, as a result of the market forces acting on the asset price, generate more or less than the prevailing interest rate. Hence there would be no investment decision problems whatever, because all assets would be equally desirable as uses of the investor’s funds.

In general it can be said that a sum of money received now is preferred to that same sum receivable at a future time. The reason for this is neither inflation nor risk. Time preference must not be confused with inflation for, although it is true that in most western countries the value of money has consistently declined over time. Even if there were no inflation, present consumption would be preferred to that in the future, even if the future consumption is absolutely certain.

This can be explained through opportunity cost. If a sum is received immediately, it can be invested in one or more projects and yield a return.A loan, for instance, will yield interest. The deferral of the receipt to a future time means that the opportunity to invest it now lost and the difference between present and future receipt can thus be understood as the opportunity cost of the investment opportunity foregone.

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