Fair Value Hierarchy Level: a method to classify bonds according to the reliability of their fair value.

Abstract

The fair value is one of the major valuation methods of financial instruments used for accounting purposes. As such, its measurement has been demanding an increasing attention and it is the object of international financial reporting standards, i.e. IFRS 13. The regulation requires the specification of a fair value hierarchy level, reflecting the level of judgment involved in estimating fair values. It is therefore deemed necessary the implementation of adequate processes for the levels determination, which are designed for the particular instrument type being considered. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities, the so-called Level 1 inputs, and the lowest priority to unobservable ones, the Level 3 inputs. This dissertation aims at addressing the hierarchy level classification for bonds, giving concrete application examples for a portfolio made up of both corporate and government securities. To handle the peculiarities of the bonds in the scope of this analysis, a decisional three has been implemented to uniquely determine the hierarchy level associated to each security. The method proposed requires at first instance the construction of ad-hoc liquidity indicators based on historical market data. The liquidity assessment and the evaluation of the suitability of a mark-to-model versus a mark-to-market approach are then some of the key turning points in the path for the determination of the fair value hierarchy level.