10.6 Measuring Fair Value When the Volume or Level of Activity for an Asset or Liability Has Significantly Decreased

10.6.1 General

ASC 820-10

Measuring Fair Value When the Volume or Level of Activity for an Asset or a Liability Has Significantly Decreased

35-54C The fair value of an asset or a liability might be affected when there has been a significant decrease in the volume or level of activity for that asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities). To determine whether, on the basis of the evidence available, there has been a significant decrease in the volume or level of activity for the asset or liability, a reporting entity shall evaluate the significance and relevance of factors such as the following:

There are few recent transactions.
Price quotations are not developed using current information.
Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.
There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, taking into account all available market data about credit and other nonperformance risk for the asset or liability.
There is a wide bid-ask spread or significant increase in the bid-ask spread.
There is a significant decline in the activity of, or there is an absence of, a market for new issues (that is, a primary market) for the asset or liability or similar assets or liabilities.
Little information is publicly available (for example, for transactions that take place in a principal-to-principal market).

35-54D If a reporting entity concludes that there has been a significant decrease in the volume or level of activity for the asset or liability in relation to normal market activity for the asset or liability (or similar assets or liabilities), further analysis of the transactions or quoted prices is needed. A decrease in the volume or level of activity on its own may not indicate that a transaction price or quoted price does not represent fair value or that a transaction in that market is not orderly. However, if a reporting entity determines that a transaction or quoted price does not represent fair value (for example, there may be transactions that are not orderly), an adjustment to the transactions or quoted prices will be necessary if the reporting entity uses those prices as a basis for measuring fair value and that adjustment may be significant to the fair value measurement in its entirety. Adjustments also may be necessary in other circumstances (for example, when a price for a similar asset requires significant adjustment to make it comparable to the asset being measured or when the price is stale).

35-54E This Topic does not prescribe a methodology for making significant adjustments to transactions or quoted prices. See paragraphs 820-10-35-24 through 35-27 and 820-10-55-3A through 55-3G for a discussion of the use of valuation techniques when measuring fair value. Regardless of the valuation technique used, a reporting entity shall include appropriate risk adjustments, including a risk premium reflecting the amount that market participants would demand as compensation for the uncertainty inherent in the cash flows of an asset or a liability (see paragraph 820-10-55-8). Otherwise, the measurement does not faithfully represent fair value. In some cases, determining the appropriate risk adjustment might be difficult. However, the degree of difficulty alone is not a sufficient basis on which to exclude a risk adjustment. The risk adjustment shall be reflective of an orderly transaction between market participants at the measurement date under current market conditions.

35-54F If there has been a significant decrease in the volume or level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate (for example, the use of a market approach and a present value technique). When weighting indications of fair value resulting from the use of multiple valuation techniques, a reporting entity shall consider the reasonableness of the range of fair value measurements. The objective is to determine the point within the range that is most representative of fair value under current market conditions. A wide range of fair value measurements may be an indication that further analysis is needed.

35-54G Even when there has been a significant decrease in the volume or level of activity for the asset or liability, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distress sale) between market participants at the measurement date under current market conditions.

35-54H Estimating the price at which market participants would be willing to enter into a transaction at the measurement date under current market conditions if there has been a significant decrease in the volume or level of activity for the asset or liability depends on the facts and circumstances at the measurement date and requires judgment. A reporting entity’s intention to hold the asset or to settle or otherwise fulfill the liability is not relevant when measuring fair value because fair value is a market-based measurement, not an entity-specific measurement.

ASC 820-10 — Glossary

Active Market

A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

ASC 820-10-35-54C through 35-54H contain guidance12 on the measurement of fair value when the volume or level of transactional activity for an asset or liability has significantly decreased. Note that even in these circumstances, the measurement must meet the objective in ASC 820-10-35-54G to be considered a fair value measurement. ASC 820-10-35-54G defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distress sale) between market participants at the measurement date under current market conditions.”

In addition to the discussion in the subsections that follow, see Section 10.8 for discussion of the use of quotes from brokers or pricing services to measure the fair value of assets or liabilities for which the volume of transactional activity has significantly decreased.

10.6.2 Inactive Markets

10.6.2.1 Active Versus Inactive Markets

ASC 820-10-20 defines the term “active market,” and ASC 820-10-35-54C lists factors that may indicate that “there has been a significant decrease in the volume or level of activity . . . in relation to normal market activity for the asset or liability (or similar assets or liabilities).” An entity should evaluate these factors to determine whether their “significance and relevance” to the asset or liability are such that they result in an inactive market; however, the presence of one or more of these factors does not in itself mean that a market is not active. Further, a decline in the volume of transactions for a particular asset or liability does not automatically make a market inactive. A market is inactive only when the frequency and volume of the transactions for the asset or liability are not sufficient to provide ongoing relevant pricing information. The characterization of a market as “active” or “inactive” may change as market conditions change.

In determining whether a market is active or inactive, an entity should focus on the trading activity of the individual asset or liability being measured rather than on the market in which it is traded. Therefore, a security that is traded infrequently on the Nasdaq could represent an asset that is not traded in an active market. However, a market is not deemed inactive simply because of insufficient trading volume relative to the size of an entity’s position.

If an entity determines that a market is inactive, it must adhere to the fair value measurement objectives addressed in ASC 820-10-35-54G and 35-54H. Accordingly, the entity cannot use entity-specific assumptions instead of relevant observable market information in measuring fair value. See Section 10.6.3.2 for discussion of the impact on a fair value measurement of an entity’s unwillingness to transact at current prices.

10.6.2.2 Distressed Sales Versus Inactive Markets

A low market demand for an asset (such as a debt security) may force prices down (i.e., supply-demand imbalances create pressure on market prices). However, in accordance with ASC 820-10-35-54I, in determining whether a transaction is orderly (and thus whether it meets the fair value objective described in ASC 820-10-35-54G), an entity cannot assume that an entire market is “distressed” (i.e., that all transactions in the market are forced or distressed transactions) and place less weight on observable transaction prices in measuring fair value. See Section 10.7 for more information about identifying transactions that are not orderly.

An entity must evaluate whether an observable transaction is not orderly (i.e., whether one of the parties is forced or otherwise compelled to transact) on a transaction-by-transaction basis, not on a market-wide basis. If orderly transactions are occurring between market participants in a manner that is usual and customary for transactions involving such assets, the entity can conclude that those transactions are not forced even if the market for such transactions is not active. An entity cannot, however, measure fair value by taking a “longer view” of the market in which the entity assumes that supply and demand will return to a reasonable balance.

In determining the price that would be received to sell an asset on the measurement date, an entity uses the assumptions that market participants would use, even if these assumptions differ from those the entity would use. For instance, if there is a quoted price in an active market for an identical asset, that quoted price generally provides the most reliable evidence of fair value and should be used to measure fair value even if the entity believes that the quoted price does not reflect long-term economic fundamentals. Alternatively, if there is no active market, the entity determines fair value by using a valuation technique (or multiple valuation techniques) that reflects current assumptions market participants would use, even if the assumptions differ from those that the entity would use in making decisions about transactions or for risk management purposes. Note that if the entity determines that the volume and level of activity for the asset have significantly decreased, transactions or quoted prices may not be determinative of fair value and the entity may be required to perform further analyses to determine whether transactions or quoted prices are orderly and whether a significant adjustment is necessary. If, after further analysis, the entity determines that the transactions are not orderly, it should place little to no weight on those transactions or quoted prices. See Section 10.7 for more information. See also Example 10-18 for an illustration.

10.6.3 Observable Transactions in Inactive Markets

10.6.3.1 General

Even if the market for an asset or liability is not active, observable transactions are relevant inputs to a fair value measurement when they reflect market participants’ assumptions in orderly transactions. Under ASC 820, an entity prioritizes relevant observable inputs when measuring fair value. ASC 820-10-35-36 states that “[v]aluation techniques used to measure fair value shall maximize the use of relevant observable inputs and minimize the use of unobservable inputs.” Further, ASC 820-10-35-53 states, in part, that “[u]nobservable inputs [Level 3] shall be used to measure fair value to the extent that relevant observable inputs [Level 1 and Level 2] are not available.”

However, when the volume and level of activity have significantly decreased and the market is not active, observable transactions may not be representative of fair value. One possible reason for this is increased instances of transactions that are not orderly (e.g., forced liquidations or distress sales). Because the level of market activity does not affect the objective of a fair value measurement (i.e., the price in an orderly transaction between market participants as of the measurement date under current market conditions), an entity must further analyze the transactions or quoted prices under ASC 820-10-35-54D to determine whether they are orderly transactions representative of fair value. See Section 10.7 for more information about identifying transactions that are not orderly.

If an entity determines that a transaction is orderly, it should consider the transaction price when estimating fair value. However, the entity may also need to adjust those transactions when determining fair value. ASC 820-10-35-54J(b) states that the “amount of weight placed on that [orderly] transaction price when compared with other indications of fair value will depend on the facts and circumstances.”

If the entity determines that it does not need to significantly adjust the transaction price on the basis of unobservable inputs to arrive at the fair value of the asset or liability as of the measurement date, the transaction price represents a relevant observable input and the measurement would be classified as a Level 2 measurement. As discussed in Section 8.4.2.1, when an entity concludes that a single valuation technique results in superior information in terms of the fair value hierarchy (e.g., this technique results in a Level 2 measurement and alternative valuation techniques would result in Level 3 measurements), it should use that measurement technique to calculate fair value. However, if the entity must significantly adjust the transaction price on the basis of unobservable inputs, the measurement would be classified as a Level 3 measurement. In such circumstances, it may be appropriate for the entity to use multiple valuation techniques and weigh different indications of fair value to determine the amount that is most representative of fair value under current market conditions.

In some circumstances, a change in valuation technique or the use of multiple valuation techniques may be appropriate (e.g., the use of a market approach and a present value technique). For example, if an entity previously used quoted prices to determine fair value and there are no available quoted prices from orderly transactions, the entity may need to change its valuation technique or use multiple valuation techniques. If the entity determines fair value by using the transaction price from a disorderly transaction, adjusted to reflect the assumptions that market participants would use in pricing the asset or liability in an orderly transaction, the resulting measurement would generally be classified as a Level 3 measurement. See Section 10.3.4 for further discussion of changes in valuation techniques.

10.6.3.2 Unwillingness to Transact at Current Prices

As discussed in Section 7.1.4, market participants must be willing to enter into a transaction for the asset, liability, or equity instrument subject to the fair value measurement. They therefore must be motivated, but not forced or otherwise compelled, to enter into the transaction. An entity that owns an asset cannot merely disregard a price from an external source simply because the entity is not a “willing” seller at that price. ASC 820-10-35-54H indicates that an entity’s intention to hold an asset is not relevant to a fair value measurement, which is market-based and not entity-specific. If the best information available in the circumstances indicates that market participants would transact at the price from an external source, it does not matter whether the entity is willing to transact at that price.

See Section 10.6.3.3 for discussion of adjustments to observable transaction prices. See also Example 10-19.

10.6.3.3 Adjustments to Observable Transaction Prices

The extent to which an entity can rely on a price obtained from an external source, and the potential adjustments necessary, depends on the facts and circumstances related to the price. The following are some considerations relevant to this evaluation:

If the price is a quoted price (unadjusted) in an active market for an identical asset or liability, or for an identical liability when traded as an asset (i.e., it is a Level 1 input), the price should be used to determine fair value unless the exception in ASC 820-10-35-41C applies (see Section 8.2.1).
If the price is the quoted price in an active market for a similar asset or liability, or for a similar liability when traded as an asset (i.e., it is a Level 2 input), the price generally serves as reliable evidence of fair value after the quoted price is adjusted for differences between the instrument being measured and the instrument underlying the quoted price (see Section 8.3.1.1).
If there is no active market but the price is for an observed transaction as of the measurement date, the entity would need to assess whether that price reflects an orderly transaction. As discussed in Section 10.7, this evaluation would affect the significance or weight that the entity would assign to that price in measuring fair value. Note that, as discussed in ASC 820-10-35-54D, a decrease in the volume or level of activity on its own does not indicate that (1) a transaction price does not represent fair value or (2) the transaction was not orderly. However, if the entity determines that the observed transaction price does not reflect an orderly transaction, an adjustment to that price will be necessary if the entity uses that price as a basis for measuring fair value. In addition, if the observed transaction price is determined to represent an orderly market transaction but that transaction did not occur on the measurement date, adjustments to reflect differences in market conditions between the date of the transaction and the measurement date will also be necessary (i.e., to reflect fair value under current conditions as of the measurement date).

ASC 820-10-35-50 through 35-54M discuss when adjustments to Level 2 inputs may be appropriate (e.g., to reflect the volume and level of activity in the market in which the input is observed). A significant decline in volume and level of market activity may indicate that an entity needs to conduct further analysis to determine whether (1) the transaction or quoted price is determinative of fair value and (2) a significant adjustment to the transaction or quoted price may be necessary for the entity to measure the fair value in accordance with ASC 820.
If a price is not based on observable market data (i.e., it is a Level 3 input), the entity may need to adjust the price or use a different valuation technique altogether to measure fair value. This may be the case if the price from the external source is not based on observable market data and the best available information in the circumstances suggests that the assumptions made by the external source differ from those a market participant would make in pricing the asset. ASC 820-10-35-54K states that in estimating fair value, an entity is not precluded from using “quoted prices provided by third parties, such as pricing services or brokers, if a reporting entity has determined that the quoted prices provided by those parties are developed in accordance with this Topic [ASC 820].” See Section 8.5 for further discussion of where prices from a broker or pricing service are categorized within the fair value hierarchy. See also Example 10-20.

In determining the types of adjustments that it may need to make to observed transaction prices, an entity may find it helpful to consider the guidance in the IASB Expert Advisory Panel report, which describes practices entities use when measuring the fair value of financial instruments. Paragraph 44 of this report states:

Factors that might lead to an adjustment to an observed transaction price for a similar instrument include (these might also be useful consideration in evaluating transactions in the same instrument):

(a) the timing of the transaction: if time has elapsed since the observed transaction, movements in market factors in the intervening period are considered and adjusted for.

(b) the terms of the instruments subject to the transaction: as economic and market conditions change, for example, market participants might require covenants for a new instrument that are different from those that were required for a previous instrument. This difference in terms affects the relative fair value of the two instruments. Furthermore, if a transaction contains complex terms and requires extensive documentation to explain the terms, market participants might demand a larger premium to compensate them for the effort required to understand and evaluate the terms of the specific instrument, or the potential additional hedging costs that might be incurred.

(c) any related transactions: for example, if a seller provides the finance for a sale to a buyer, and this finance is not at a market rate (and assuming there is no other transaction taking place), an adjustment is made to the transaction price to reflect the effect of the funding on that price.

(d) the correlation between the price of the instrument that is the subject of the observed transaction and the price of the instrument being measured: in general, the greater the correlation between the two instruments, the more relevant the observed transaction price is likely to be. When assessing correlations, it is important to remember that observed historical correlations cannot always be expected to continue, particularly if market conditions have changed.

In addition, if an entity uses a quoted price for a similar instrument in its valuation technique, the entity may need to make an adjustment to reflect differences in risk, including liquidity differences. For example, the instrument being measured may be in greater relative supply than a similar instrument for which a quoted price exists. In this situation, a liquidity risk difference would need to be factored into the fair value calculation as an adjustment to the quoted price of the other instrument.

An entity may also measure the fair value of a liability or instrument classified in its stockholders’ equity by using the quoted price of a similar but not identical item traded as an asset. In this case, the quoted price should be adjusted for factors specific to the asset that do not apply to the fair value measurement of the liability or equity instrument. ASC 820-10-35-16D indicates that an adjustment may be required when (1) the quoted price for the asset is related to a similar (but not identical) liability or equity instrument held by another party as an asset or (2) the unit of account for the asset is not the same as that for the liability or equity instrument. See Section 10.2.7 for further discussion.

See also Section 10.8.3 for discussion of the use of multiple quotes from brokers or pricing services.

10.6.4 Examples

Example 10-18

Distressed Sale Versus Inactive Market

Entity P holds an asset-backed debt security for which there is no active market. As a result of uncertainty about current and future prospects for the assets backing the security, there has been a sharp reduction in the number of potential investors for these securities in the market, increased price volatility, and a severe decline in liquidity. Investor demand for other similar debt securities has also decreased significantly. The decline in market demand forces prices down significantly, and risk premiums increase.

Entity P believes that the “true value” of the debt security is substantially higher than current observable transaction prices. In estimating the fair value of the debt security, P wants to take a “longer view” of the market under which supply and demand will return to a reasonable balance (sometimes known as “base value”). Such a view is premised on a conclusion that the entire market is “distressed.” Therefore, P plans to disregard current liquidity conditions and risk premiums in determining fair value.

In accordance with ASC 820, P is not permitted to determine fair value on the basis of a “longer view” of the market and cannot assume that an entire market is distressed. Rather, P should determine fair value by considering the price a willing market participant would pay for the debt security in an orderly transaction on the measurement date under current market conditions. Accordingly, P must evaluate whether any observable transactions, even if there are not very many, are orderly. Entity P is required to consider the impact that current market conditions, including illiquidity and imbalances in supply and demand (and the associated risk premiums), have on the price that would be received to sell the asset on the measurement date. Because a hypothetical transaction is assumed to be on the measurement date in a fair value measurement, it would generally be inappropriate for P to conclude that there are no willing buyers and no willing sellers.

Example 10-19

Valuation of Debt Securities by Using Income Approach on the Basis of Observable Market Data

Entity Q is using a valuation technique to determine the fair value of its holdings of privately placed corporate debt securities issued by Entity X. No quoted price for identical securities is available. Entity Q’s valuation technique takes into account assumptions about default rates and discount rates. Default rate assumptions can be readily derived from current observable market data for actively traded credit default swaps on X’s publicly traded bonds. In determining fair value, Q cannot disregard such market data even if it would not be willing to transact at a price consistent with the data. For a discussion of the use of internal data when market data exist, see Section 8.1.2.

Example 10-20

Distressed Sale Versus Inactive Market

Entity R holds distressed debt securities. There is no active market for the securities, but transactions occur infrequently and there are active markets for similar securities. Entity R’s own valuation model, which is based on observable Level 2 inputs current as of the measurement date, indicates that market participants would be willing to buy and sell the debt for $30 on the measurement date provided that marketing activities are usual and customary for transactions in similar securities. Entity R has calibrated the model by using the best information available as of the measurement date (including transaction prices related to comparable securities and risk premiums).

On the measurement date, a potential buyer provides an unsolicited bid to buy the securities for $20. While R cannot disregard the bid price simply because it is not willing to transact at that price, R cannot assume that the bid price serves as better evidence of fair value than its own model. The bid price is the price one potential buyer would be willing to pay for R’s asset but is not necessarily the price at which market participants (buyers and sellers) would be willing to transact on the measurement date.

ASC 820 requires that valuation techniques used to measure fair value maximize the use of relevant observable inputs (i.e., Level 1 and Level 2 inputs that do not require significant adjustment) and minimize the use of unobservable inputs (Level 3 inputs). If the bid price is classified as a Level 3 input and R’s own model is based on Level 2 inputs, it may be appropriate for R to place less weight on the bid price in determining fair value. If R obtains several bid prices and the model amount is not in the range of prices obtained, however, it may be appropriate to challenge whether the model is valid and identify the reasons for the discrepancy.

If R’s valuation technique involves obtaining prices periodically from potential buyers to determine fair value and validate the model amount, R should continue to apply this technique consistently unless a change would result in a measurement that is equally or more representative of fair value in the circumstances.

Example 8 in ASC 820-10-55-90 comprehensively illustrates how an entity measures fair value when the volume or level of activity for an asset or liability has significantly decreased:

ASC 820-10

Example 8: Measuring Fair Value When the Volume or Level of Activity for an Asset or a Liability Has Significantly Decreased

55-90 This Example illustrates the use of judgment when measuring the fair value of a financial asset when there has been a significant decrease in the volume or level of activity for the asset when compared with normal market activity for the asset (or similar assets). (See paragraphs 820-10-35-54C through 35-54H.) This Example has all of the following assumptions:

Entity A invests in a junior AAA-rated tranche of a residential mortgage-backed security on January 1, 20X8 (the issue date of the security).
The junior tranche is the third most senior of a total of seven tranches.
The underlying collateral for the residential mortgage-backed security is unguaranteed nonconforming residential mortgage loans that were issued in the second half of 20X6.
At March 31, 20X9 (the measurement date), the junior tranche is now A-rated. This tranche of the residential mortgage-backed security was previously traded through a brokered market. However, trading volume in that market was infrequent, with only a few transactions taking place per month from January 1, 20X8, to June 30, 20X8, and little, if any, trading activity during the nine months before March 31, 20X9.

Pending Content (Transition Guidance: ASC 820-10-65-13)

Entity A invests in a junior AAA-rated tranche of a residential mortgage-backed security on January 1, 20X8 (the issue date of the security).
The junior tranche is the third most senior of a total of seven tranches.
The underlying collateral for the residential mortgage-backed security is unguaranteed nonconforming residential mortgage loans that were issued in the second half of 20X6.
At March 31, 20X9 (the measurement date), the junior tranche is now A-rated. This tranche of the residential mortgage-backed security was previously traded through a brokered market. However, trading volume in that market was infrequent, with only a few transactions taking place per month from January 1, 20X8, to June 30, 20X8, and little, if any, trading activity during the nine months before March 31, 20X9.

55-91 Entity A takes into account the factors in paragraph 820-10-35-54C to determine whether there has been a significant decrease in the volume or level of activity for the junior tranche of the residential mortgage-backed security in which it has invested. After evaluating the significance and relevance of the factors, Entity A concludes that the volume and level of activity of the junior tranche of the residential mortgage-backed security have significantly decreased. Entity A supported its judgment primarily on the basis that there was little, if any, trading activity for an extended period before the measurement date.

55-92 Because there is little, if any, trading activity to support a valuation technique using a market approach, Entity A decides to use an income approach using the discount rate adjustment technique described beginning in paragraph 820-10-55-10 to measure the fair value of the residential mortgage-backed security at the measurement date. (See also paragraphs 820-10-35-36 through 35-36A.) Entity A uses the contractual cash flows from the residential mortgage-backed security. The discount rate adjustment technique described beginning in paragraph 820-10-55-10 would not be appropriate when determining whether there has been a credit loss and/or a change in yield in accordance with paragraph 325-40-35-4 when that technique uses contractual cash flows rather than most likely cash flows.

55-93 Entity A then estimates a discount rate (that is, a market rate of return) to discount those contractual cash flows. The market rate of return is estimated using both of the following:

The risk-free rate of interest
Estimated adjustments for differences between the available market data and the junior tranche of the residential mortgage-backed security in which Entity A has invested. Those adjustments reflect available market data about expected nonperformance and other risks (for example, default risk, collateral value risk, and liquidity risk) that market participants would take into account when pricing the asset in an orderly transaction at the measurement date under current market conditions.

55-94 Entity A took into account the following information when estimating the adjustments in the preceding paragraph:

The credit spread for the junior tranche of the residential mortgage-backed security at the issue date as implied by the original transaction price
The change in credit spread implied by any observed transactions from the issue date to the measurement date for comparable residential mortgage-backed securities or on the basis of relevant indices
The characteristics of the junior tranche of the residential mortgage-backed security compared with comparable residential mortgage-backed securities or indices, including all of the following:
1. The quality of the underlying assets, that is, information about all of the following:
  1. Delinquency rates
  2. Foreclosure rates
  3. Loss experience
  4. Prepayment rates.
2. The seniority or subordination of the residential mortgage-backed security tranche held
3. Other relevant factors.
Relevant reports issued by analysts and rating agencies
Quoted prices from third parties such as brokers or pricing services.

55-95 Entity A estimates that one indication of the market rate of return that market participants would use when pricing the junior tranche of the residential mortgage-backed security is 12 percent (1,200 basis points). This market rate of return was estimated as follows:

Begin with 300 basis points for the relevant risk-free rate of interest at March 31, 20X9.
Add 250 basis points for the credit spread over the risk-free rate when the junior tranche was issued in January 20X8.
Add 700 basis points for the estimated change in the credit spread over the risk-free rate of the junior tranche between January 1, 20X8, and March 31, 20X9. This estimate was developed on the basis of the change in the most comparable index available for that time period.
Subtract 50 basis points (net) to adjust for differences between the index used to estimate the change in credit spreads and the junior tranche. The referenced index consists of subprime mortgage loans, whereas Entity A’s residential mortgage-backed security consists of similar mortgage loans with a more favorable credit profile (making it more attractive to market participants). However, the index does not reflect an appropriate liquidity risk premium for the junior tranche under current market conditions. Thus, the 50 basis point adjustment is the net of two adjustments.
1. The first adjustment is a 350 basis point subtraction, which was estimated by comparing the implied yield from the most recent transactions for the residential mortgage-backed security in June 20X8 with the implied yield in the index price on those same dates. There was no information available that indicated that the relationship between Entity A’s security and the index has changed.
2. The second adjustment is a 300 basis point addition, which is Entity A’s best estimate of the additional liquidity risk inherent in its security (a cash position) when compared with the index (a synthetic position). This estimate was derived after taking into account liquidity risk premiums implied in recent cash transactions for a range of similar securities.

55-96 As an additional indication of the market rate of return, Entity A also takes into account 2 recent indicative quotes (that is, nonbinding quotes) provided by reputable brokers for the junior tranche of the residential mortgage-backed security that imply yields of 15 to 17 percent. Entity A is unable to evaluate the valuation technique(s) or inputs used to develop the quotes. However, Entity A is able to confirm that the quotes do not reflect the results of transactions.

55-97 Because Entity A has multiple indications of the market rate of return that market participants would take into account when measuring fair value, it evaluates and weights the respective indications of the rate of return, considering the reasonableness of the range indicated by the results.

55-98 Entity A concludes that 13 percent is the point within the range of indications that is most representative of fair value under current market conditions. Entity A places more weight on the 12 percent indication (that is, its own estimate of the market rate of return) for the following reasons:

Entity A concluded that its own estimate appropriately incorporated the risks (for example, default risk, collateral value risk, and liquidity risk) that market participants would use when pricing the asset in an orderly transaction under current market conditions.
The broker quotes were nonbinding and did not reflect the results of transactions, and Entity A was unable to evaluate the valuation technique(s) or inputs used to develop the quotes.

Footnotes

This guidance, which amended FASB Statement 157, was issued in 2009 in response to fair value measurement issues that arose during the credit crisis that began in 2007.

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