The Risk and Risk-free Rate of T-bills

This study argues that a future payment’s risk approaches zero as maturity approaches zero. We employ two factors to model the risk-free rate (which is captured by the central bank’s short-term rate) that the market expects the current monetary policy to move towards the neutral level over a certain period. We expect that the T-bill risk captures the macro-risk (i.e., inflation risk) of a future payment. Our 3-factor final model thus splits recent yields of US and Canada T-bills into the risk and risk-free rate, on average explaining 97% of the yields. Our modeling is a gateway to equity risk and macro-risk and micro-risk (i.e., firm risk) of corporate bonds.