Definition
Level 2 Assets are financial assets and liabilities whose values are based on prices or inputs that are not exactly observable on open markets but can be determined through mathematical modeling or other valuation methodologies. These inputs may include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in non-active markets, or other inputs that can be corroborated by observable market data. Examples of Level 2 Assets are certain derivatives, private equity investments, and real estate.
Phonetic
“Level 2 Assets” in phonetics is: /ˈlevəl tuː ˈæsɛts/
Key Takeaways
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- Level 2 assets are those whose fair value can be determined by direct or indirect market observables. Here, the inputs used in pricing the asset or liability are not the exact same ones that could be seen in a market place, but they are based on them.
- These frequently involve various forms of financial derivatives, structured products, complex bonds, pension liabilities or even private equity investments. However, compared to Level 1 assets, they are less liquid and harder to value.
- Since Level 2 assets can’t be as easily priced as Level 1 assets, it may be more difficult to determine a conclusive market value. Thus, they can carry a higher level of risk for the investor due to this increased uncertainty related to their pricing.
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Importance
Level 2 Assets are an important aspect of business and finance as they directly relate to the valuation and overall financial health of a company. They represent financial instruments whose fair values can be determined based on observable market data, such as stock prices, interest rates, or exchange rates, though they are not as easily quantifiable as Level 1 Assets. Because of this, Level 2 Assets provide a more complex picture of a company’s value, requiring specialized knowledge and techniques to accurately assess. The proper valuation of Level 2 Assets is crucial for a transparent and comprehensive view of a company’s portfolio, mitigating potential risks, and informing investment or financial reporting decisions.
Explanation
Level 2 assets are a category of assets that are relatively less liquid and have a somewhat subjective value compared to Level 1 assets, which have clear, observable market prices. The value of Level 2 assets is determined using ‘mark to market’ accounting practices. This entails judging the value of the asset based on similar ones in the marketplace and adjusting it according to the market conditions in day-to-day operations. Common examples of Level 2 assets are mortgage-back securities or thinly traded stocks.The purpose of Level 2 assets is to provide an alternative form of investment that can offer higher potential returns compared to Level 1 assets. However, this comes with higher potential risk due to the lack of readily available market prices. For corporations, level 2 assets can serve as a form of capital reserve that can be leveraged for future investments or financial obligations. Furthermore, they can also provide a buffer against losses in other areas of the company’s operations. As such, understanding the value of Level 2 assets is crucial when evaluating the financial health and stability of a company.
Examples
Level 2 Assets refer to assets whose value or price cannot be readily determined through observable market data. However, they can be valued with reasonable accuracy by relying on other observable inputs in the market. Here are three examples involving Level 2 assets:1. Corporate bonds: Although corporate bonds are regularly traded, in some cases, they may not have an easily observable price on a public exchange. However, their value can be determined using observable inputs such as the interest rates of similar bonds, yield curves, or credit risk information.2. Real Estate: The price of real estate is not directly observable in an active market and can be significantly influenced by the specific conditions of the property and its location. As a result, real estate is often considered a Level 2 asset. Their value can be approximated based on observable indicators like recent sales prices of similar properties, property condition, and location.3. Over-the-counter (OTC) derivatives: OTC derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediaries. Since they are not exchange-traded, their prices aren’t readily observable. But their value can be determined with reasonable accuracy using valuation models that incorporate inputs like exchange rates, commodity prices, or interest rates, which are observable in the market.
Frequently Asked Questions(FAQ)
What are Level 2 Assets?
Level 2 Assets are a category of assets that are fairly difficult to value due to a lack of liquidity or a market. They are not actively traded and therefore, their prices are determined using models or pricing methodologies.
How are Level 2 Assets valued?
Since Level 2 Assets are not actively traded, their valuation is based on observable inputs that aren’t Level 1 inputs. This may include quoted prices for similar assets, benchmark yield curves, volatility measurements, and credit risks.
What is an example of a Level 2 Asset?
Examples of Level 2 Assets may include mortgage-backed securities, complex derivatives, and private equity investments.
How are Level 2 Assets different from Level 1 and Level 3 Assets?
Level 1 Assets are the easiest to value because their values are based on quoted prices in active markets. Level 3 Assets are the hardest to value because their valuation involves unobservable inputs, and are often based on a company’s own assumptions. Level 2 Assets fall in-between as they involve some degree of estimation or model inputs but are also based on observable market data.
Who decides the classification of an asset into Level 2?
The classification of an asset into Level 1, 2, or 3 is determined by the asset valuation hierarchy outlined by the Financial Accounting Standards Board (FASB) in their accounting guidelines.
Why are Level 2 Assets important to understand in assessing a company’s finance?
Understanding Level 2 Assets is important because they can represent significant risk to a company due to their relative lack of transparency. Their value can be subject to significant changes which can impact a company’s balance sheet.
How often are Level 2 Assets revalued?
Level 2 Assets should be re-evaluated at least once a year, as per FAS (Financial Accounting Standards). However, more frequent valuation may be done if there is a significant event or change in the market conditions relevant to the asset.
Related Finance Terms
- Mark-to-market valuation
- Financial Accounting Standards Board (FASB)
- Fair Value Measurement
- Illiquid Assets
- Level 1 and Level 3 Assets
Sources for More Information
