Question
Which of the following best describes the interest on
government bonds?Solution
• The risk-free rate is the theoretical return on an investment that carries zero risk of default. • In practice, no investment is entirely risk-free, but government bonds (especially those of stable governments) are considered the closest proxy since they are backed by sovereign authority and the likelihood of default is negligible. • Hence, the interest on government bonds is generally treated as the risk-free rate in models like CAPM (Capital Asset Pricing Model).
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