Fair Value Measurement Accounting in the Absence of Prudence: An Illustration with Exotic Derivatives
Authors
Marabel Romo, Jacinto; Guiral Contreras, Andrés; Crespo Espert, José Luis; Gonzalo Angulo, José Antonio; Moon , DoocheolIdentifiers
Permanent link (URI): http://hdl.handle.net/10017/60326DOI: 10.1080/02102412.2016.1258027
ISSN: 0210-2412
Date
2017Bibliographic citation
Revista Española de Financiación y Contabilidad / Spanish Journal of Finance and Accounting, 2017, v. 46, n. 2, p. 145-167
Keywords
Fair value
Prudence
Exotic options
Model misspecification error
Implied volatility
Local volatility
Stochastic
Volatility
Document type
info:eu-repo/semantics/article
Version
info:eu-repo/semantics/publishedVersion
Rights
© Taylor and Francis Group
Attribution-NonCommercial-NoDerivatives 4.0 International (CC BY-NC-ND 4.0)
Access rights
info:eu-repo/semantics/openAccess
Abstract
The aim of this paper is to contribute to the current discussion about Fair Value Accounting (FVA), especially, when accounting standard setters have eliminated from their conceptual frameworks any reference to prudence. We discuss the problematic surrounding FVA by relying on the role played by prudence, its meaning, and how the treatment of prudence has changed in the accounting framework of standard setters due to its ?apparent? inconsistency with neutrality. To highlight the relevance of this issue, we provide (1) a brief analysis of the high impact that Level 2 fair value estimates have on large U.S. and European banks? financial positions; (2) a ?case study? by pricing two common exotic derivatives and comparing the valuation results of two different assumptions of volatility (local vs. stochastic); and (3) a discussion of potential solutions to the problematic surrounding FVA. Ours findings are consistent with the argument that neutrality is supported by the exercise of prudence in achieving a faithful representation, since a non-conservative use of FVA can lead bank managers toward model misspecification error in the valuation of complex financial instruments. We conclude by arguing that the problematic surrounding FVA can be mitigated if prudence is reinstated by standards setters.
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