The Risk and Risk-free Rate of T-bills

We argue that a payment’s risk approaches zero as maturity approaches zero, and that the central bank’s short-term rate best captures the risk-free rate of various assets. We employ two factors to model the expected risk-free rate that the market expects the current monetary policy to move towards the neutral rate over a certain period. Expecting that the T-bill risk (i.e., the macrorisk) largely reflects a country’s inflation risk, we measure the risk as a 5-year payment’s risk to be comparable across assets. We use repeated trials to minimize the prediction errors to solve the model factors. Our models thus split US and Canada T-bill yields into the risk and risk-free rate, on average explaining 98.8% of the returns. The models assuming the return independence even show stronger power in predicting T-bill returns. We also find that a negative risk of several basis points, which is constant over maturity, probably reflects the transaction cost or the risk of inter-back short-term lending. The risk and the risk-free rate represent the gateway to the risks of various corporate assets in the country.