It is not uncommon to encounter a scenario where two valuations of the same business—prepared six months apart using the same methodology—produce materially different results. The divergence is often not driven by changes in cash flows, growth assumptions, or operating performance, but by movements in a single input: the risk-free rate.

This highlights why the selection of the risk-free rate warrants careful scrutiny, particularly in periods of heightened volatility in sovereign yields.

In principle, the risk-free rate should be derived from a long-dated sovereign bond corresponding to the longest maturity on the yield curve that remains actively traded, as this provides the most reliable observable proxy for long-term risk-free expectations. Short-term instruments are generally unsuitable for valuing long-term cash flows.

The selected bond should be actively traded in the secondary market, as non-traded instruments reflect historical issuance conditions rather than prevailing market expectations. Where secondary market activity is limited, reliance on coupon rates is unlikely to provide a reliable estimate of the risk-free rate.

Market depth and liquidity are critical considerations. Larger benchmark issues are typically preferred, as they attract a broader investor base and support efficient price discovery. Liquidity may be assessed using trading volumes, turnover ratios, and bid-ask spreads. Tight spreads and frequent trading indicate reliable pricing, while widening spreads often signal liquidity constraints.

Where these conditions are met, the spot, mark-to-market yield as at the valuation date should ordinarily be used, as it reflects all information available to market participants at that point in time. In limited circumstances involving identifiable market dislocation, the application of professional judgment, supported by evidence and transparent disclosure, may be appropriate.

Material movements in sovereign yields over time can legitimately result in different valuation outcomes across valuation dates. Such differences do not imply inconsistency but rather reflect the market’s evolving assessment of risk.

Finally, it is essential to clearly distinguish between the risk-free rate, sovereign default spread, and market risk premium, as mixing up these inputs undermines valuation integrity and confidence in reported values.

Disclaimer:
The views expressed are personal and do not reflect those of my employer or any affiliated entities.