Karen Nunez

Project Title: Reporting Frequency, Sample Structure, and the

Effectiveness of Fair Value Net Income as a Measure of Risk

This project examines the properties of Fair Value Net Income (FVNI) as a measure of
business risk. It also relates these properties to important implementation issues such as
measurability, reporting frequency, and cost. Our analysis is developed in the context of
bank trading portfolios, which are currently accounted for at market value and thus
represent an ideal framework for examining ‘fair value’ based risk metrics. While
explicit findings address the risks of bank trading portfolios, the issues addressed are also
relevant to proposed extensions of fair value reporting methods to broader classes of
assets and liabilities. The methodological contributions of the study include the
application of analytic and simulation methods to overcome sample limitations
encountered in conventional empirical and experimental approaches.

VAR and earlier portfolio risk measures such as ‘maturity gap’ and
duration originated as ways to reveal risks not apparent from
conventional GAAP accounting methods. The utility of these methods
is evidenced by their widespread use by financial institutions, typically
going far beyond the measures now mandated by regulation. With the
broad acceptance of these methods, we can now speak of at least
three distinct ‘dimensions’ of financial information used by banking
institutions: accrual method net income, cash flow, and risk
measures grounded in fair value methodology.

The introduction of fair value as an alternative basis for net income

complicates the distinctions between these three established
dimensions of management information and control. Fair value net
income appears to compete directly with the accrual income concept
as the central indicator of firm performance. Risk information
conveyed by fair value net income also overlaps with results from
established VAR methods. While VAR carries the conceptual
advantage of reflecting only current exposures, FVNI potentially
conveys similar information in a manner that is far less dependent on
esoteric modeling processes.

The risk informativeness of FVNI, however, is highly dependent on the

sample period over which it is observed. Rate information can largely
overcome limitations in FVNI sample variability, since effects of small
movements in the risk driver can be used to roughly estimate
exposure to larger changes. Unfortunately, outside the financial
sector, we generally lack explicit measures for primary drivers of
business risk. For example, risks to the FVNI of a software firm,
broadly construed, have little to do with interest rates. Lacking
explicit information on risk drivers, FVNI must be observed over a
sufficiently long, diverse and commensurable historical period to
reveal latent risks of the firm. Meanwhile, market dynamics may
change significantly, shortening the useful time period for measuring
the firm's current economic exposures.
Observation frequency is also a key contributor to the informativeness
of FVNI. Frequent observations allow us to infer risk from a shorter
time period, helping assure our measurements speak to the firm’s
current position. In general, however, frequent measurement and
reporting is quite costly. Current GAAP net income, with its complex
rules and dependence on estimates such as depreciable life and loss
reserves, probably ranks among the more expensive of financial
metrics to produce and audit. The fair value of liquid trading
portfolios is relatively easy to calculate and audit, but expansion of
fair value methods beyond their relatively narrow current domain will
involve significant costs. Consequently, the relationship between
reporting frequency and the information content of FVNI is highly
relevant to the future shape and direction of accounting standards
and risk measurement practices.

Our research will seek to address the following issues in turn:

1. Elucidate some fundamental principles regarding the

relationship between sample structure and information content,
as well as the interactions between risk ‘drivers’ and stochastic
outcomes.

2. Empirically assess the informativeness of FVNI streams,

appropriately weighted for contemporaneous rate movements,
for risk assessment in the special case of bank trading
portfolios. We compare these results to alternative metrics
such as VAR, building on earlier work by Jorion, Liu, and Hirst.

3. Discuss some practical implications of our findings for the

expansion of fair value methods to broader areas of financial
reporting and enterprise risk management.