Fair Market Values serve as proxies for market value estimates. For liquid securities, such as treasury bills or large cap stocks, the fair value is often synonymous with the most recent price or last trade. In the event of a trading halt or pending news, the last transaction serves as the seed price for the expected new price.
In the past, Fair Market Values were often considered as the anticipated price for a transaction between a rational buyer and rational seller, neither which was acting under duress or subject to extraordinary factors.
Stocks, bonds, currencies, real estate, futures, options, and other derivatives are candidates for Fair Market Valuations. This pricing process often goes hand-in-hand with mark-to-market efforts. This is critical because it attempts to establish a reasonable nominal value for instruments or properties which do not trade as frequently yet are a part of the overall marketplace.
For example, bonds are typically decomposed into the stated coupon and principal payments. This stream of income and return of capital or principal is then discounted. The sum of the discounted payments is then the computed "Fair Value." However, this relatively straightforward technique can become problematical. This occurs when selecting the discount factor for each stream of income and principal payment. Should the factor be one number or should each payment have an unique discount factor? Are these factors solely predicated on the the treasury yield curve? Is there to be an adjustment for Credit Risk? Illiquidity? Currency Risk? Volatility? Prepayment Risk? And Reinvestment Risk? This is a brief listing of variables.
The usual technique to calculate Fair Market Values entails determining the time horizon of the security, an appropriate discounting factor, and a suitable volatility estimate for optional instruments.
Stock Market Indices: Fair Market Valuations
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