After studying this chapter, you should be able to:
A few years ago, a bank reported an $87.3 million write-down on its mortgage-backed securities. However, the bank stated that it expected its actual losses to be only $44,000. The loss of $44,000 was equal to a modest loss on a condo foreclosure. The bank's regulator found “the accounting result absurd.” However, the rest of the story is that the bank a year later raised its credit-loss estimate by $263.1 million, quite a difference from its original loss estimate of $44,000.
This bank example highlights the challenge of valuing financial assets such as loans, derivatives, and other debt investments. The fundamental question that emerged out of the example above and, more significantly, the recent financial crisis is: Should financial instruments be valued ...