Motivation. Consider you are a company which just did an IPO. The amount of money you get from selling shares at the IPO price, is different from the market cap. Which one should you use for your balance sheets? def. Fair Value of Asset is the estimate price if you liquidated it on the market right now. For liabiity assets (¶loan) it is the estimate price for selling that loan to another company (=exit value). But, not all assets are traded actively on a high-volume market, and sometimes you never know what the price of an asset is until you’ve actually sold it. So we have three tiers of defining fair value, the best to worst:
- Level I (Mark-to-market) quoted prices on active market
- Level II (Mark-to-market with objective inputs): quoted prices on active market for similar instruments, or by valuation techniques (like Black-Scholes for derivatives) from the (inputs of) active price of underlyers.
- The Risk-Neutral Measure for pricing applies this principle.
- Level III (Mark-to-market with subjective inputs): valuation techniques where inputs are not all active market prices