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Valuation of liabilities - CH 33

C

Claudio

Member
I have noticed that under some of the methods used for valuing the liabilities such as the market-based approach and the risk-neutral market-consistent approach, it says that the discount rate we use should be a deduction from the rate we use to allow for default risk (and any other associated risks).
So for the market-based approach, it says there would be a deduction from the expected return due to default risk. Similarly, under the risk-neutral armlet consistent approach, it says any risk elements from the risk-free yield should be stripped out.

I am just a bit confused as to why we do this. Is it to be more conservative, so by reducing the discount rate we allow for the risks (like default) by having a higher value on our liabilities?
 
Hi Claudio,

The course notes say that for coming up with a risk-free rate, we need to ensure that any 'risk' element in the yields need to be taken out, to make it fully risk free. Likewise with the market-based approach reflecting assets held, we would want the actual return, without considering the 'additional' rate for default.

Liabilities won't default, so we'd want to reflect that in valuing the liabilities.
 
Hi,

I had a doubt in the fair value of liabilities. It is mentioned that in the fair valuation of liabilities, should be independent of any assets backing the liabilities. However, the definition of "fair value says its the price that would be paid to sell an asset or transfer a liability...". From the definition it is clear that we might consider the value of an asset while estimating the fair value of the liability. Then why does it say that the valuation is independent of the assets backing the liabilities?
 
Hi Sayantani

The first quotation you included ('price that would be paid to sell an asset or transfer a liability') is covering the fair value of an asset or the fair value of a liability separately, rather than stating any reliance on the fair value of assets to get the fair value of liabilities. We may consider assets when placing a fair value on liabilities, but not the assets backing the liabilities if these are not a match for the liabilities (by amount, currency, duration, nature, etc) - it could then be that we take the fair value of a hypothetical portfolio of assets that match the liability as the fair value of the liabilities.

Hopefully this helps.
 
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