Key Takeaways
- Valued using observable inputs, not active market quotes.
- Middle tier in fair value hierarchy (ASC 820/IFRS 13).
- Includes assets like OTC derivatives and inactive market bonds.
What is Level 2 Assets?
Level 2 assets represent financial instruments measured at fair value using observable market inputs other than quoted prices for identical items in active markets. Under GAAP and IFRS, they form the middle tier of the fair value hierarchy, positioned between highly liquid Level 1 assets and more subjective Level 3 assets.
This classification typically applies when you value assets based on similar securities in inactive markets or use observable inputs such as interest rates from the par yield curve rather than direct market quotes.
Key Characteristics
Level 2 assets share distinct traits that differentiate them within the fair value hierarchy:
- Observable inputs: Valuations rely on market data like interest rates or credit spreads, rather than unadjusted quotes.
- Market corroboration: Prices are supported by external data, making them more reliable than Level 3 assets.
- Examples: Interest rate swaps and corporate bonds traded in inactive markets.
- Valuation models: Use inputs such as the Macaulay duration to assess risk and value.
- Intermediate liquidity: Less liquid than Level 1 assets like bond ETFs (best bond ETFs), but more transparent than Level 3 holdings.
How It Works
Valuing Level 2 assets involves applying valuation techniques that maximize the use of observable inputs, such as quoted prices for similar assets or market-based data like interest rates from the par yield curve. When direct market prices are unavailable, models incorporate this observable data to estimate fair value objectively.
These assets often include over-the-counter derivatives or debt securities where prices are not publicly quoted, requiring you to rely on external market data to reduce subjectivity compared to Level 3 valuations. The determination of Level 2 status depends on the lowest-level significant input used in the valuation process.
Examples and Use Cases
Level 2 assets are common in various financial sectors, serving specific roles in portfolios and risk management:
- Airlines: Delta and American Airlines may hold Level 2 assets like interest rate swaps to hedge fuel price volatility.
- Corporate bonds: Debt securities traded infrequently but valued using similar bond prices and yield curves.
- Fixed income funds: Bond funds such as BND often include Level 2 securities to diversify credit exposure.
- Derivatives: Over-the-counter contracts whose fair value depends on observable market inputs.
Important Considerations
When managing Level 2 assets, ensure that the observable inputs used are current, relevant, and derived from independent sources to maintain valuation integrity. Misclassification between Level 2 and Level 3 can lead to regulatory scrutiny and misstatement risks.
Understanding the differences between Level 1, 2, and 3 assets is crucial, especially when assessing portfolio liquidity and transparency. Leveraging reliable market data, such as that found in best bond ETFs, can enhance valuation accuracy and support compliance with accounting standards like GAAP.
Final Words
Level 2 assets provide a balance between market-based valuation and model-driven estimates, offering more reliability than Level 3 inputs but less than Level 1. To ensure accuracy in your financial reporting or investment analysis, regularly review the observable inputs and consider consulting valuation experts when market conditions shift.
Frequently Asked Questions
Level 2 assets are financial assets and liabilities valued using observable market data that is not based on quoted prices for identical items in active markets. They occupy the middle tier in the fair value hierarchy and include items like interest rate swaps and corporate bonds in inactive markets.
Level 2 assets differ from Level 1 assets, which use unadjusted quoted prices for identical assets in active markets, and Level 3 assets, which rely on unobservable inputs such as internal assumptions. Level 2 uses observable inputs like prices for similar assets or market data such as interest rates.
Common Level 2 assets include interest rate swaps, over-the-counter derivatives valued with observable inputs, privately held company stock with limited trading, and corporate bonds or debt securities in inactive markets that are valued using comparable prices or observable yield curves.
Level 2 assets have medium reliability because their valuation uses observable market data other than direct quoted prices for identical assets, such as prices for similar items or market inputs like yield curves. This makes them more objective than Level 3 but less so than Level 1 assets.
Fair value for Level 2 assets is determined using valuation techniques that maximize observable inputs like quoted prices for similar items or market data such as interest rates and credit spreads, while minimizing reliance on unobservable inputs to ensure objectivity.
If observable market inputs are not available or fail to meet observability criteria, the asset’s classification shifts from Level 2 to Level 3, where valuation relies more heavily on unobservable inputs and internal assumptions.
Level 2 assets are commonly held by private equity firms, insurance companies, and banks, as these entities often deal with financial instruments that require valuation using observable but not directly quoted market data.
