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ABC is a publicly traded commercial bank. ABC records investments in debt securities as either trading securities or available - for - sale securities .
ABC is a publicly traded commercial bank. ABC records investments in debt securities as either trading securities or
availableforsale securities
On March ABC invested in an S&P AArated tranche of a Collateralized Debt Obligation CDO The
underlying collateral for the CDO is a pool of US Treasury and corporate bonds. Before September ABC
was able to measure the fair value of the CDO by using a marketbased valuation technique that relies on inputs such
as quoted prices in active markets for similar CDO securities and requires only insignificant adjustments for
differences between the CDO security held by ABC and similar CDO securities
However, since September the market for CDO securities has experienced a significant decrease in the
volume and level of activity. This was made apparent by the following two factors:
Significant widening of the bidask spreads in the brokered markets in which the CDO securities trade; this
widening continued throughout QX
Progressively significant decrease in the volume of trades compared with historical levels in Q No
recent transactions have taken place.
After evaluating the significance and relevance of the factors above, ABC determined that there has been a
significant decrease in the volume and level of activity, the CDOs market was not active, and significant
adjustments to observed market transactions of similar CDO securities are required to measure fair value as of the
measurement date December given the lack of recent and relevant transactions. ABC determined that any
adjustments made to the observed market transactions would be based on managements assumptionsregarding market
values.
In addition, ABC determined that an income approach valuation technique present value technique that maximizesthe
use of relevant observable inputs and minimizesthe use of unobservable inputs will be more representative of fair value
than would the market approach valuation technique used on prior measurement dates June and September
X Specifically, ABC uses the discount rate adjustment technique discussed below to measure fair value.
On the basis of the following factors, ABC determined that the appropriate discount rate for the contractual cash flows
of the CDO security is percent:
The implied rate of return on September the last date on which ABC determined the market to be
active for the CDO security was percent. Since September ABC estimates that credit spreads have
widened by approximately percent and liquidity risk premiums have increased during that period by
approximately percent. Other risks eg interest rate risk have not changed.
Two nonbinding indicative quotes for the CDO security from brokers implied rates of return of percent
and percent. The indicative quotes are based on the brokers proprietary models that use hypothetical
assumptions instead of actual transactions.
ABC concluded that percent is the point within the range of relevant inputs that is most representative of
fair value which consisted of a percent implied rate of return, a percent credit adjustment, a
percent liquidity risk adjustment, and a percent management adjustment to reflect current market
conditions and other factors evidenced by nonbinding broker quotes.
Therefore, ABC determined that the riskadjusted discount rate appropriately reflects the entitys estimate of the
assumptions that market participants would use to estimate the selling price of the asset in an orderly transaction as of
the measurement date under current market conditions. ABC also determined that the following inputs were significant
to the measurement in its entirety: implied rate of return, credit adjustment, and liquidity risk adjustment.
Required:
Determine the appropriate classification in the fair value hierarchy for each of the instruments referenced in the case as of
December Provide support from appropriate authoritative guidance. Consider the following:
ABCs determination of whether the respective markets for the instruments were active or inactive and whether
there was a significant decrease in the volume and level of activity for the instruments.
The classification in the fair value hierarchy for each input into the fair value measurement and how those
classifications affect classification in the fair value hierarchy of the entire instrument
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