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How Do I Determine the Fair Value of Financial Instruments?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 29 August 2014
  • Copyright Protected:
    2003-2014
    Conjecture Corporation
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Financial instruments involve a wide range of documents that have some type of monetary value, including currency, bonds, and shares of stock. When deciding whether to buy or sell any of these instruments, there is a need to identify the fair value of financial instruments involved, making it easier to decide if the transaction is likely to result in some sort of gains. Depending on the nature of the asset involved, factors such as the current market price, the futures price involved, and any additional expenses that may be involved in owning the asset.

A good place to begin with determining the fair value of financial instruments is to consider the current market price. Buyers will want to compare that price to the asking price that the seller is offering. It is important to remember that while market price and asking price may be the same, there are situations in which sellers are willing to sell below the market price in order to generate cash quickly, and other situations in which the seller may try to sell above market price based on the projected performance of the instrument in the future.

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Take some time to look into those projections as part of the process of determining the fair value of financial instruments. Ideally, those projections should indicate that the asset will increase in value over time, making it worth the effort to buy it now. While indications of increasing market value are helpful, use this only as a qualifying characteristic, and not as the final determinant of the fair value.

Assuming the asset in question is expected to continue to increase in market value in the future, consider other expenses related to ownership before attempting to ascertain the fair value of financial instruments. For example, if the asset in question happens to be commodities, it is important to allow for ancillary costs such as storage and carrying expenses. Allowing for these can make it easier to decide the fair value of financial instruments in relation to the liabilities that will be incurred after choosing to make a purchase,

Keep in mind that while determining the fair value of financial instruments does include some amount of subjective thought on the part of the buyer or seller, attempting to keep the process as grounded in fact is very important. Balancing intuition and knacks with cold hard facts can go a long way toward preventing a transaction that is ultimately not in the best interests of the investor. By being more objective, the chances of arriving at a fair value for the asset is greatly increased, and the potential for benefiting from the transaction in some manner is much more likely.

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