FAS 157 - Derivative valuation insights
Under FAS 157 companies must measure fair value by segregating observable and unobservable inputs into Level 1, Level 2, and Level 3 inputs: Level 1 inputs are market observed inputs such as quoted prices (e.g. equity prices); Level 2 inputs refer to using quoted prices as inputs to construct the price for an instrument (e.g. interest rate swap); and Level 3 inputs refer to unobservable inputs (e.g. calibrated model parameters) used to derive the fair value.
The biggest fundamental change FAS 157 introduced in measuring fair value or assessing market value for a financial asset or liability is when there isn't a market of observable inputs - for Level 2 and 3 inputs companies should use a mark-to-model valuation technique to determine the fair value of an instrument. When any degree of uncertainty arises as to the value of an instrument due to a lack of observable data, a mark-to-model approach should be used.
While many of the investment banks have invested in the infrastructure required to comply with FAS 157, a large number of public companies have not. For those that have not, they will need to do so by the first quarter of 2008. As companies search for a solution, they should pay particular attention to how they will overcome their Level 2 and 3 input requirements.
OTC Valuations Limited, a provider of transparent and auditable valuation and risk reports for over-the-counter derivatives, has published a whitepaper that provides derivative valuation insights into measuring fair value under FAS 157. The paper provides guidance in the use of Level 1, 2, and 3 inputs; defines the differences between mark-to-market, matrix, consensus, and mark-to-model pricing; illustrates the advantages of using a mark-to-model valuation technique; reviews bid and ask price considerations; and provides guidance in overcoming derivative valuation challenges.
OTC Val employs multiple valuation techniques to address the Level 1, 2, and 3 input requirements of FAS 157. For derivatives that can be replicated with vanilla, liquidly-traded, instruments and valued in a model-independent way, the focus is on mark-to-market valuation using high-quality market data from leading brokers and data vendors. For exotic and structured products with limited price discovery and imperfect replication, OTC Val's market professionals offer mark-to-model valuation based on careful calibration of industry standard models.
Bob Sangha, one of the founders of OTC Val, elaborates, "We provide our clients fair value transparency through unbiased valuations based on quoted market data, carefully calibrated models, and proven valuation methodologies."
You can download a copy of the whitepaper FAS 157 - Derivative Valuation Insights .
Contributed by Bob Sangha, OTC Valuations Ltd.