Wednesday, 22 October 2008

On the value of uncertainty

Long, long ago, when I was responsible for the valuation of a lot of financial instruments at an investment bank, I used to set a lot of store in valuation adjustments. The basic idea is that the precise fair value of many instruments is uncertain. You value them at your best guess, and you take a valuation adjustment to cover the potential uncertainty. They are a kind of accounting error bar, if you like.

There are two main reasons to do things this way rather than simply to mark conservatively. The first is that value affects risk: if you mark as accurately as possible, your risk measures are as accurate as possible. [This is particularly an issue for derivatives since d (delta) / d (vol) is non-zero: marking to a 'conservative' implied vol gives you the wrong deltas.] The second is that the size of the valuation adjustments are an important signal to management about the size of the valuation uncertainty in the book. That in turn gives important information on illiquidity, marketability etc.

Borio in a fascinating BIS paper The financial turmoil of 2007- argues that firms should disclose these uncertainties, and that this disclosure would be a useful disclosure to the users of financial statements. I agree completely. The only problem is that many people currently think that some firms would be insolvent based on plausible error bars. But they don't know precisely who those firms are.

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