Fair Value and Its Economic Consequence on the Volatility Measures of Earnings, Stock Price and Government Debt Yield

Abstract

Many banks and commentators argued that fair value accounting was the root caused the procyclical decline in bank assets and capitals, the failures of large financial sector and extreme volatility in financial asset prices during the GFC. Fair value measurements may result in different figures for earnings and capital, both of which are important as buffers against insolvency. Fair value may also convey different messages to the market, either value relevance or volatility, it will lead to different economic consequences in allocating capital resource. This study is an attempt to review the studies of fair value and its impact on earnings volatility and stock price volatility and takes a step further it shows the way in which fair value could potentially introduce volatility into the financial system in particularly a mathematical derivation shows that the government bonds volatility is affected by earnings volatility and its decomposition of fair value and historical cost earnings volatilities. As such, fair value may contribute to a highly volatile market and general investors need to understand the tradeoff between fair value relevance and volatility in making an in vestment decision.