Fair value
From Wikipedia, the free encyclopedia
Fair value, also called fair price, is a concept used in finance and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such factors as:
- relative scarcity
- perceived utility (economist's term for subjective value based on personal needs)
- potential risk/return characteristics (i.e., for a tradable asset)
- replacement costs, or costs of close substitutes
- production/distribution costs, including a cost of capital
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[edit] Fair value vs market price
There are two schools of thought about the relation between the market price and fair value in any kind of market, but especially with regards to tradable assets:
- The efficient market hypothesis asserts that, in a well organized, reasonably transparent market, the market price is generally equal to or close to the fair value, as investors react quickly to incorporate new information about relative scarcity, utility, or potential returns in their bids; see also Rational pricing.
- Behavioral finance asserts that the market price often diverges from fair value because of various, common cognitive biases among buyers or sellers. However, even proponents of behavioral finance generally acknowledge that behavioral anomalies that may cause such a divergence often do so in ways that are unpredictable, chaotic, or otherwise difficult to capture in a sustainably profitable trading strategy, especially when accounting for transaction costs.
[edit] Fair Value Measurements (US markets): Exposure Draft
The Financial Accounting Standards Board (FASB) issued Exposure Draft 1201-100 on June 23, 2004, to provide proposed guidance about how entities should determine fair value estimations for financial reporting purposes. The draft would apply broadly to financial and nonfinancial assets and liabilities measured at fair value under other authoritative accounting pronouncements. Absence of one single consistent framework for applying fair value measurements and developing a reliable estimate of a fair value in the absence of quoted prices has created inconsistencies and incomparability. The purpose of this exposure draft is to eliminate the inconsistencies by developing a solid framework to be used in any fair value measurements.
The draft suggests the following definition for fair value: the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties. It notes that the price is an estimate in the absence of an actual exchange.
The exposure draft emphasizes the use of market inputs in valuing an asset or liability. The specific market inputs mentioned include: quoted prices, interest rates, yield curve, credit data, etc. Fair value is, by definition, derived from a current transaction which happens in an active market with knowledgeable and unrelated parties. When fair value is not available due to the lack of an actual transaction, it is logical to use information from an active market. However, sometimes quoted prices might not represent the best estimate of fair value.
The basis of the framework in the exposure draft centers on a fair value hierarchy. The hierarchy is suggested as a guide to determining what inputs to include in valuing an asset or liability at fair value. The hierarchy is broken down into three levels. Level One requires the use of quoted prices from an active market for identical assets or liabilities. To use this level, the entity must have immediate access to the market (could exchange in current condition). If more than one market is available, the exposure draft requires the use of the “most advantageous market.” Both the price and costs to do the transaction must be considered.
Level Two requires the use of quoted prices for similar assets or liabilities in active markets. While in Level One an entity is not permitted to make any change to the quoted price, an entity may make price adjustments, as necessary, in Level Two since the assets or liabilities are only similar, not identical. It is stated, however, that any adjustment must be objective. If the adjustment is not objective or there are no similar goods in the active market, an entity must measure the fair value based on Level Three. This level requires the use of valuation techniques. The draft suggests the use of the market, income, and cost approach, unless the use of all three produces undue costs and effort. If that is the case, an entity is to use the approach that produces the best approximation of the fair value. Inputs used to determine the value should be external to the entity. The entity may only rely on internal information if the cost and effort to obtain external information is too high.
A working draft has been established for the fair value exposure draft. The working draft was released for comment on October 21, 2005. One of the noticeable changes in the working draft compared to the exposure draft is the addition of two more levels in the fair value hierarchy. Level three has been adjusted to only include assets or liabilities that have observable inputs other than quoted prices. It is also explained that financial instruments must have an input that is observable over the entire term of the instrument. The addition of the additional levels helps to eliminate the ambiguity associated with the first exposure draft. Instruments that have inputs that are not directly observable, but have corroboration through other data, are considered level four. Level Five encompasses any remaining valuation that requires all entity inputs and no market inputs.
