What it is:
A risk-free asset is an asset that provides a virtually guaranteed return.
How it works (Example):
Treasury bills are the most common example of risk-free assets. Because the U.S. government has the authority to simply print money, there is virtually no risk that those who lend money to the government (via the purchase of Treasurys) will not receive their interest and principal payments when due.
Why it Matters:
Risk-free assets enjoy more attention and demand in volatile markets and periods of uncertainty.
The notion of the risk-free asset is a fundamental component of the capital asset pricing model, the Black-Scholes option pricing model, and modern portfolio theory, because it essentially sets the benchmark above which assets that contain risk should perform. Of course no asset is truly risk free -- there is always at least some possibility, no matter how minute, that the U.S. government will not be able to repay its debt, for example. But that risk is considered so minute as to be virtually zero.
Regardless of the debate over the true statistical probability of default on risk-free assets, it's important to note that risk-free assets also face inflation risk, whereby the earnings are eaten away at by inflation over time. Also, risk-free assets like Treasuries also carry interest-rate risk, meaning that when interest rates rise, Treasury prices fall, and vice versa. Fortunately, in periods of rising interest rates, Treasury prices tend to fall less than other bond do.