The concept of fair value hierarchy
Respond to these two replies with a question on the end. Only has to be about 150 words each.
How do you value level 3 assets given that they’re so difficult to value?
“There are also 3 levels of hierarchy in determining fair value. Level one refers to unadjusted, quoted prices for the same assets (liabilities) in the market. Level two relies on inputs included in level 2, but allows for values of similar assets or those in other markets. Level three allows for the use of inputs that are not observable. This means that if there are no comparable assets or there is no market activity to compare to.” This caused me to investigate further on the levels of hierarchy in determining value.
What I discovered is that while the levels of hierarchy deterrmine methods of valuation, it is based upon how observable the measurements are. It does not, for instance, relate the values to the level of relative risk. Although a level two asset may be more observable, it does not necessarily follow that it is less risky.
Also, it is a misconception to apply levels of liquidity to the levels of determining fair value. A level two asset may be no more, or less, liquid than a level three asset. In some instances, although an asset may be able to be sold in a relatively short amount of time, there may be a loss of observability in the process so, it could move that asset from a level two to a level three.
Some examples of the different levels, using investment instruments are:
Level one – Stocks and bonds listed on national exchanges
Level two – U.S. Public debt, or short-term cash instruments
Level three – Some fixed income asset-backed securities or complex derivatives
The concept of fair value hierarchy is not as simple as it first appears. There are complexities involved and each situation must be evaluated from all sides to increase consistency and transparency.
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