What is the risk-free interest rate and how does it relate to pricing a bond
There are two reasons the yield of a defaultable bond exceeds the yield of an otherwise identical default-free bond. 2.The expected return of a corporate bond, which is the firm's debt cost of capital, equals the risk-free rate of interest plus a risk premium. The risk-free rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the risk-free rate is commonly considered to equal to the interest paid on a 3-month government Treasury bill, generally the safest investment an investor can make. The Risk-free interest rate is the return on investment with no loss-of-capital risk. In practice, this does not exist. In theory, it is an important parameter in option pricing as it sets the baseline price upon which risk premium should be added. A practical estimate to the risk-free interest rate is taken from 'risk-free' bond issued by the government or agency where the default risk is