Handbook of Asset and Liability Management: From models to optimal return strategies

6

“Economic Accounting”: Fair Value and Full Fair Value

Entre trop et trop peu est la juste mesure. (Gilles de Noyers)

The full fair value concept is derived from the fair value concept developed by the IFRS. Indeed, full fair value extends fair value to every product including products accounted at historical cost.

For every product, we compute the full fair values:

• using an available quoted market prices; or
• using a discounted cash flow analysis.

The discounted cash flow analysis has to take into account all the flows associated with the product: capital repayments, interests. The A/L manager discounts these cash flows under a risk neutral probability (or under a martingale risk neutral probability minimizing the risk using the Girsanov theorem).

Moreover, full fair value is equal to the expectancy of the sum of all the future discounted incomes. Indeed, on the long-term horizon, all the accounting standards are equivalent.

Nevertheless, many A/L managers fought against the introduction of full fair value in the IFRS rules: they categorically resisted this accounting methodology.

First, they were afraid of the possibility of accounting manipulations by their competitors. However, their main objection was to the risk of income volatility, that full fair value introduces. This volatility comes from the difficulty of computing fair value and achieving a stable formula, i.e. a formula with the least incertitude possible. Moreover, this volatility creates greater complexity for ...