Abstract
Many banks and commentators argued that fair value accounting was the root caused the procyclical decline in bank assets and capitals, the failures of large financial sector and extreme volatility in financial asset prices during the GFC. Fair value measurements may result in different figures for earnings and capital, both of which are important as buffers against insolvency. Fair value may also convey different messages to the market, either value relevance or volatility, it will lead to different economic consequences in allocating capital resource. This study is an attempt to review the studies of fair value and its impact on earnings volatility and stock price volatility and takes a step further it shows the way in which fair value could potentially introduce volatility into the financial system in particularly a mathematical derivation shows that the government bonds volatility is affected by earnings volatility and its decomposition of fair value and historical cost earnings volatilities. As such, fair value may contribute to a highly volatile market and general investors need to understand the tradeoff between fair value relevance and volatility in making an investment decision.
Highlights
BackgroundResearchers study the economic consequences of adopting fair value accounting as part of IFRS and find that fair value measures are more value relevant in explaining stock prices
Studies of Fair Value and Economic ConsequencesResearchers study the economic consequences of adopting fair value accounting as part of IFRS and find that fair value measures are more value relevant in explaining stock prices
This study has shown that the government bonds volatility is affected by earnings volatility and its decomposition of fair value and historical cost earnings volatilities, stock price volatility, and the covariance between fair value earnings and historical cost earnings, the covariance between fair value earnings and stock prices, and the covariance between historical cost earnings and stock prices
Summary
Researchers study the economic consequences of adopting fair value accounting as part of IFRS and find that fair value measures are more value relevant in explaining stock prices. (2014) Fair Value and Its Economic Consequence on the Volatility Measures of Earnings, Stock Price and Government Debt Yield. We suggest that fair values FV are estimated as the present value of expected future cash flows associated with the asset or liability, discounted by an appropriate discount rate which is the risk free rate plus a risk premium. The mathematic derivation of the association between fair value and market volatility is based on the equilibrium relationship between earnings, stock prices and government bond yields. Yardeni [24] [25] modified the above equation and assume a simplest case if the equity risk premium is equal to zero, and derived the risk free rate as: rf This is known as the Fed Model which later is used as a simple tool to measure the trade-off between two competing asset classes investment, equities versus bonds.
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