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02 Sep 2009Working Paper Summaries

Information Risk and Fair Value: An Examination of Equity Betas and Bid-Ask Spreads

by Edward J. Riedl and George Serafeim
What is the role of fair values in the current economic crisis? The interplay between information risk—that is, uncertainty regarding valuation parameters for an underlying asset—and the reporting of financial instruments at fair value has been a subject of high-level policy debate. Finance theory suggests that information risk is reflected in firms' equity betas and the information asymmetry component of bid-ask spreads. HBS professor Edward Riedl and doctoral candidate George Serafeim test predictions for a sample of large U.S. banks, exploiting recent mandatory disclosures of financial instruments designated as fair value level 1, 2, and 3, which indicate progressively more illiquid and opaque financial instruments. Overall, banks with higher exposures to level 3 financial assets have both higher equity betas and higher bid-ask spreads. Both results are consistent with higher levels of information risk, and thus cost of capital, for these firms. Key concepts include:
  • Banks with higher exposure to level 3 (or more illiquid) financial assets reflect higher information risk, revealed both in higher equity betas and higher bid-ask spreads.
  • This is suggestive that current disclosures surrounding level 3 financial instruments are insufficient to mitigate investor perceptions of greater information risk for highly opaque financial assets.
  • The regulatory implications may include enhancements to the disclosures (particularly for level 3 financial instruments), as well as increased movement towards risk-weighted regulatory capital.

Author Abstract

Finance theory suggests that information risk—that is, the uncertainty regarding valuation parameters for an underlying asset—is reflected in firms' equity betas and the information asymmetry component of bid-ask spreads. We empirically examine these predictions for a sample of large U.S. banks, exploiting recent mandatory disclosures of financial instruments designated as fair value level 1, 2, and 3, which indicate progressively more illiquid and opaque financial instruments. Consistent with predictions, results reveal that portfolios of level 3 financial assets have higher implied betas and lead to larger bid-ask spreads relative to those designated as level 1 or level 2 assets. Both results are consistent with a higher cost of capital for banks holding more opaque financial assets, as reflected by the level 3 fair value designation. Keywords: banks, risk, fair value, financial instruments. JEL Codes: G12, G14, G21, M41. 43 pages.

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