Definition
The risk-free rate is the theoretical return on an investment with zero probability of default. In practice, the yield on Canadian federal government 90-day Treasury bills (T-bills) is used.
**Use in mortgage finance**: - Base of bond pricing model (TVM) - Any additional premium (spread) compensates for specific risk: credit risk, liquidity risk, duration risk - Fixed mortgage rate = risk-free rate + term premium + bank credit premium + profit margin
**Policy rate vs. risk-free rate**: The BoC policy rate is often confused with the short-term risk-free rate — they move together but are not identical (the overnight rate target targets the interbank rate, not T-bills directly).
**Practical relevance**: For a borrower, understanding that each mortgage rate incorporates several premiums above the risk-free rate helps negotiate: a bank offering a higher rate than competitors simply has a higher margin, not higher risk.