Developing a valuation framework for an illiquid security

Abstract

Purpose: The latest financial crisis has highlighted the need for increased transparency and scrutiny of illiquid asset valuations. The aim of this paper is to see how and by how much a listed bond's intrinsic value would needs to be discounted to cover illiquidity costs and represent fair value. Therefore, it intends to develop a valuation framework for illiquid listed bonds. As a result, the objectives include: 1. Identify local valuation practices of illiquid securities, particularly for listed bonds, 2. Develop a methodology to assess a listed bond's liquidity, 3. Developing a basis to determine the illiquidity discount for illiquid bonds being in compliance with IFRS. Design: This research has mainly used a qualitative approach by carrying out unstructured interviews with respondents from the largest financial institutions in Malta, the Big 4 and the accountancy board. Furthermore, quantitative research was also carried out to obtain relevant financial information about local financial institutions. Findings Local financial entities are found to be very conservative in their investment policies, limiting investment in less liquid and lower quality securities in favour of highly liquid and safe bonds. A security's liquidity is generally given higher importance than credit quality. Additionally, the majority of local bond holdings are reported at fair value. Conclusions: Based on the literature and respondents' feedback the study sets out a framework for imputing illiquidity costs within a bond's value. This involves determining a bond's level of liquidity through a list of liquidity indicators and a structure for determining the illiquidity discount within listed bond valuation models. Implications / Value: The framework can aid professional judgement in detecting the level of a bond's liquidity, and to impute the cost of illiquidity within bond valuation models so that it adequately represents fair value.