Measuring the fair value of financial instruments within a portfolio

The staff opened the discussion by noting that the topic was one of the most controversial issues in the fair value measurement project and was the main issue that financial institutions wanted to discuss with the IASB after the publication of the exposure draft (ED) Fair Value Measurement in May 2009. Those constituents were concerned that the proposals in the ED would:

• change practice significantly with respect to how entities measure the fair value of financial instruments managed within a portfolio;
• result in significant operational challenges and costs; and
• result in financial reporting being divorced from risk management systems.

The staff undertook intensive outreach activities with several large financial institutions to determine how entities measure financial instruments within portfolios in practice. The agenda paper noted two approaches to measurement - the individual instrument approach and the portfolio approach. The staff recommended that a portfolio approach be permitted. In that approach, the unit of account and the unit of valuation might differ. This is the approach currently used in practice for measuring the fair value of financial instruments that are managed within a portfolio.

Bid-ask

The staff recommended that the boards permit entities:

1. to use mid-prices as a basis for establishing fair values for offsetting (ie long and short) market risk positions (as market risk is defined in IFRS 7), and
2. to apply the price within the bid-ask spread that is most representative of fair value to the net open risk position.

Such an approach would be limited to circumstances in which:

1. the entity manages its financial instruments on the basis of the net open risk positions in accordance with the entity's documented risk management strategy (that is, it would not apply to entities that 'exit' a financial instrument by selling or transferring an individual financial instrument, but it would apply to entities that 'exit' a financial instrument by entering into an offsetting risk position).
2. the market risks (for example, interest rate risk, currency risk, or other price risk) that are being offset are substantially the same.
3. the financial instruments share common characteristics (for example, maturities).
4. the financial instruments are measured at fair value on a recurring basis.

There was much disquiet with this recommendation. Some Board members thought it was inviting inappropriate entity-specific measurements, in particular because of the way entities would be allowed to assemble the portfolios for measurement purposes. Those Board members criticised a staff comment that the value of the portfolio depends on the other instruments held by the entity and the entity's risk preferences. The use of 'depends' in this statement created a presumption of an entity-specific measure. Those Board members also thought that an entity's risk preferences had no bearing on measuring fair value.

Other Board members were more sympathetic: they saw it as a pragmatic approach that aligned financial reporting models with best practices in business.

The Boards eventually concluded that the staff proposal could be supported; however, it must be described as an exception to the general principle in the Fair Value Measurement standard. Board members continued to be concerned about establishing discipline around the net positions being measured. Both Boards supported the staff recommendations by majorities.

Counterparty credit

The Boards agreed to permit entities to consider offsetting counterparty credit risk positions when measuring the fair value of financial instruments when there is a legally enforceable right of offset (such as in a master netting agreement) with the counterparty in the event of bankruptcy (or other default).

Again, some Board members were unhappy with the staff recommendation - some seeing it as an inappropriate use of offsetting, compounding the measurement error. However, others were happier to see the measurement proposals used in this situation than in the bid-ask spread situation, above. The staff recommendations were agreed by majorities in both Boards.