If government bonds in a country are not considered risk-free, how should you determine the risk-free rate?

Determining the risk-free rate in a scenario where government bonds are not considered risk-free involves understanding the concept of a risk-free rate as a theoretical benchmark against which other investments are measured.

The most appropriate approach in this case is to take the risk-free rate from a stable country, which typically has a low chance of default and a strong economy. Adding a default spread accounts for the additional risk associated with the particular country in question. This approach effectively adjusts for the fact that local government bonds may have inherent risks that could lead to default, thereby providing a more accurate representation of the risk-free rate applicable to the investment analysis.

Using the risk-free rate from a stable country ensures you start with a reliable baseline, while the addition of a default spread tailors this rate to align with the specific risks posed by the local economic environment. This method reflects a nuanced understanding of risk assessment, bridging the gap between a theoretical risk-free rate and the practical realities of investing in less stable regions.