Proxies For The Risk-free Rate
The return on domestically held short-dated government bonds is normally perceived as a good proxy for the risk free rate. However, theoretically this is only correct if there is no perceived risk of default associated with the bond. Government bonds are conventionally considered to be relatively risk-free to a domestic holder of a government bond, because there is by definition no risk of default - the bond is a form of government obligation which is being discharged through the payment of another form of government obligation (i.e. the domestic currency). (Tobin, Money, Credit and Capital, page 16.) This implies the risk of the government 'printing more money' to meet the obligation is perceived as a form of tax, rather than a form of default, (the inflation tax)which is often discussed as similar concept to that of 'seigniorage'.
The same consideration does not necessarily apply to a foreign holder of a government bond,since a foreign holder also requires compensation for potential foreign exchange movements in addition to the compensation required by a domestic holder. Therefore it is normally the case that currency debasement is viewed as a form of default for foreign holders. Since the risk free rate should theoretically exclude any risk of default, this implies that the yields on foreign owned government debt cannot be used as the basis for calculating the risk free rate.
Since the required return on government bonds for domestic and foreign holders cannot be distinguished in an international market for government debt, this may mean that yields on government debt are not a good proxy for the risk free rate.
Another possibility used to estimate the risk free rate is the inter-bank lending rate. Again appears to be premised on the basis that these institutions benefit from an implicit guarantee, underpinned by the role of the monetary authorities as 'the lending of last resort.' (It should be appreciated that in a system with endogenous money supply the 'monetary authorities' may be private agents as well as the Central Bank.) Again, the same observation applies to banks as a proxy for the risk free rate - if there is any perceived risk of default implicit in the interbank lending rate, it is not appropriate to this rate as a proxy for the risk free rate.
Similar conclusions can be drawn from other potential benchmark rates, including short rated AAA rated corporate bonds of institutions deemed 'too big to fail.'
Unfortunately it has not been possible to locate a well detailed discussion on the basis of the various conventions for estimating the risk free rate through proxy rates, which appears to be a major 'hole' in the theoretical literature.
One solution that has been proposed for solving the issue of not having a good 'proxy' for the risk free asset, to provide an 'observable' risk free rate is to have some form of international guaranteed asset which would provide a guaranteed return over an indefinite time period (possibly even into perpetuity). There are some assets in existence which might replicate some of the hypothetical properties of this asset. For example, one potential candidate is the 'consul' bonds which were issued by the British government in the 18th century.
Read more about this topic: Risk-free Interest Rate
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