Valuation basics

AuthorHellwig, Martin F.
Valuation reports in the context of banking resolution: What are the challenges?Valuation reports in
the context of banking resolution: What are the challenges?
PE 624.417 7
The concept of “value” involves an exercise in counterfactuals. The assessment of value therefore
depends on which counterfactuals one considers and what assumptions one makes about them.
Importantly, the assessment of value also depends on which course of action one considers. Which
method of valuation is appropriate may therefore depend on the purpose for which the information
contained in the valuation is used.
2.1 The Counterfactual Nature of Valuations
The statement “Object x is worth y euros” refers to a potential exchange of the object against money.
As a statement from the owner, it may indicate a willingness to sell the ob ject for y euros; as a statement
from a potential buyer, it may indicate a willingness to buy it for y euros. Such statements from
interested participants however involve an important element of subjectivity, perhaps also an attempt
at manipulating the terms of an intended exchange.
The impact of subjectivity is reduced or even eliminated if the sentence is read as a statement about
trading opportunities in a market. For example, if object x is a financial asset that is traded in an
organized exchange, the statement might mean that the prevailing market price is y euros. More
generally, the “fair value” of object x is y euros, if an owner can reasonably expect to find a buyer at this
price and a potential buyer can reasonably expect to find a seller at this price.
As a statement about fair value, the sentence “Object x is worth y euros” does not presume that the
transaction in question actually takes pl ace. However, unless the transaction actually takes place, there
is no way of knowing whether it really is possible to trade the object for y euros.
When trading happens in a frictionless organized market, without information asymmetries and
without market power of participants, the counterfactual nature of valuation poses no serious problem.
Apart from the fact that overnight news may cause tomorrow’s price to be different from today’s price,
in such a market, today’s price is a fairly precise predictor of the price at which the object will be traded
in the near future.
When these conditions are not satisfied, however, the counterfactual nature of valuation can cause
serious problems. If markets are not well organized, it may be difficult to find a trading partner in
reasonable time.
Even worse, the very attempt to trade may cause the market price of the object to change. This
phenomenon arises, in particular, from effects of asymmetric information and/or market power.
Asymmetric information can give rise to the so-called “lemons” effect, whereby the very attempt of an
owner to sell an object is interpreted as a signal that the object is of poor quality.2 Such information
effects will cause the price of the object to fall as a consequence of the owner’s trying to sell it. For
example, in the context of a bank with a portfolio of non-performing loans, the very attempt to sell the
portfolio may provide the market with a signal that default probabilities are even higher than
anticipated causing potential buyers to require higher discounts.
Market power effects can occur when the trader in question is relatively large. An example would be a
central bank trying to sell its gold stock in the open market. Another example would be a corporation
2 See Akerlof (1970).

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