What Are Level 2 Assets Liquidity Pricing Guide

Core Description

• Level 2 assets are valued using observable but indirect market inputs, such as yield curves and broker quotes, making them more complex than Level 1 but less opaque than Level 3.
• They offer a balance between yield and risk, providing investors with diversification and moderate liquidity, but require thorough pricing and risk management.
• A clear understanding of their classification, valuation, risks, and practical application is essential for building diversified portfolios and meeting fair value accounting standards.

Definition and Background

Level 2 assets are a central component of the fair value measurement hierarchy defined by standards such as IFRS 13 and ASC 820. These standards classify financial assets and liabilities into three levels, depending on the observability and reliability of pricing inputs:

• Level 1 Assets: Valued using quoted prices in active markets for identical securities (for example, S&P 500 stocks, Treasury bonds), providing maximum transparency and liquidity.
• Level 2 Assets: Valued based on observable inputs that are not direct quoted prices for identical items but are derived from market data (such as yield curves, credit spreads, or dealer indications)—inputs that are indirectly observable but still market-based.
• Level 3 Assets: Valued using significant input from unobservable data or internal models, resulting in the greatest valuation uncertainty.

Level 2 assets gained prominence after FAS 157 established the fair value hierarchy in 2006-2007 and with the adoption of IFRS 13 in 2011. Their role expanded after significant market events like the global financial crisis in 2008 and the COVID-19 market stress, when investors and institutions relied on observable, though not always actively traded, data to determine fair value.

Key characteristics:

• Moderate liquidity, but not as deep as Level 1 assets.
• Rely heavily on market data—benchmark rates, spreads, or structured pricing models.
• Price discovery often involves interpolation, matrix pricing, or adjusted dealer quotes.
• Examples include thinly traded corporate bonds, agency mortgage-backed securities (MBS), municipal bonds, over-the-counter (OTC) derivatives such as interest rate swaps, and plain-vanilla OTC options.

Understanding Level 2 assets is important for investors, risk managers, and financial controllers, as these often make up a significant proportion of the portfolios at financial institutions and investment funds.

Calculation Methods and Applications

Valuing Level 2 assets typically requires blending observable market data with quantitative valuation models. Key methods include:

1. Matrix Pricing

Matrix pricing estimates a less-liquid bond’s value using yield spreads and the prices of comparable bonds with similar ratings, industries, and maturities.

General bond pricing formula:

P = Σ [CF(t) / (1 + y(t))^t]

Where:

• P = bond price
• CF(t) = cash flow at time t
• y(t) = yield, typically from a benchmark curve (such as US Treasury), plus an option-adjusted spread (OAS) and a liquidity premium

Process:

• Identify benchmark yield curves (for example, US Treasury curve)
• Determine OAS and liquidity premium by analyzing more liquid, similar bonds
• Adjust for embedded options as needed using option-adjusted spread models

2. Discounted Cash Flow (DCF) Using Observable Inputs

DCF models use observable discount curves (for example, Overnight Index Swap (OIS) curves or government bond curves) to estimate asset values. Future cash flows are discounted by interest rates and observable credit spreads that reflect market pricing.

3. OTC Derivative Valuation

OTC derivatives, such as interest rate swaps or options, are generally valued by calibrating models (such as Black–Scholes for options, swap valuation formulas) using implied volatility and forward rates inferred from other, actively traded instruments.

• Swaps: Present value of fixed and floating legs, discounted using OIS-forward rates from market data
• Options: Use implied volatility derived from similar exchange-traded options

4. Yield Curve Bootstrapping

Discount factors or forward curves are built using observed prices from deposits, futures, and swaps. For missing maturities, interpolation and extrapolation are performed using appropriate techniques, such as cubic Hermite splines.

5. Credit and Liquidity Spread Estimation

Spreads are estimated using combinations of market quotes, ratings, sector analysis, and observed trading activity. Economic models may help, but validation of market data is a priority.

6. Pricing Conventions

• Bonds: Valued at "clean price" plus accrued interest
• Deduct reserves for bid-ask spreads, model risk, and liquidity adjustments to achieve fair value

Primary Uses of Level 2 Assets

• Yield enhancement and diversification in portfolios
• Liability-driven investing by pension funds and insurers
• Hedging with OTC derivatives when Level 1 prices are not available
• Regulatory and financial reporting where observable, but not perfectly liquid, quotes are required

Comparison, Advantages, and Common Misconceptions

Comparison: Level 1, Level 2, and Level 3 Assets

Advantages

• Diversification: Level 2 assets cover a variety of sectors, structures, and geographies, helping reduce concentration risk.
• Yield Enhancement: Frequently offer a "liquidity premium," meaning higher yields compared to Level 1 in exchange for reduced market depth.
• Moderate Transparency: Use observable, though indirect, market data, mitigating the subjectivity of Level 3 asset valuations.

Disadvantages

• Imperfect Liquidity: Wider bid-ask spreads and less reliable exit pricing, especially under market stress.
• Valuation Complexity: Requires multiple data sources and regular back-testing; susceptible to valuation errors if underlying data are stale or based on non-executable quotes.
• Model and Data Reliance: Even observable inputs need interpolation or adjustments that may change rapidly in periods of distress.

Common Misconceptions

Level 2 Means Illiquid or Hard to Value

Level 2 assets are not always illiquid. True illiquidity becomes an issue mainly at Level 3. The key factor is reliance on observable but indirect market inputs.

“Level II” Market Data Equals Level 2 Assets

"Level II" data in equity trading relates to order book depth and is not connected to fair value asset classifications. Level 2 in accounting refers to the source and nature of valuation input.

All Derivatives Are Level 2

Some derivatives are Level 1 (exchange-traded), and only certain OTC derivatives priced with observable inputs are Level 2. More complex or exotic structures may be Level 3.

Dealer Quotes Are Level 1 Prices

Dealer quotes are generally indicative and only Level 1 if firm and from an active market. Otherwise, such quotes are Level 2 inputs and must be validated for fair value.

Stale or Uncorroborated Inputs Are Sufficient

Using outdated or unverified inputs may misstate values, particularly in volatile markets. Regular updating and cross-checking of data are essential.

Practical Guide

Identification and Scope

• Identify Level 2 assets: These are securities without active exchange prices but with observable market data (for example, yield curves, credit spreads, broker quotes).
• Common examples: Thinly traded corporate bonds, agency MBS, OTC interest rate swaps with observable but non-exchange-traded valuations

Valuation Framework and Market Inputs

• Source multiple broker quotes and corroborate them with trading data and market curves from similar instruments
• Apply matrix pricing, DCF, and option models, making conservative adjustments for liquidity, optionality, and other relevant risk factors
• Regularly backtest valuation models with recent trade executions or third-party evaluator marks

Liquidity Management and Execution

• Use Request-for-Quote (RFQ) platforms and staggered order execution to manage lower market depth
• Factor in all-inclusive costs, such as bid-ask spreads and potential slippage
• Ensure readiness for settlement cycles and observe minimum lot sizes required by counterparties

Risk Measurement and Stress Testing

• Assess metrics beyond volatility, such as spread duration, key rate exposure (DV01), convexity, credit migration risk, and liquidity haircuts
• Implement stress scenarios using both historical events and forward-looking hypotheticals

Portfolio Allocation and Diversification

• Allocate to Level 2 assets for increased yield within prudent issuer, sector, and tenor constraints
• Use them to diversify beyond Level 1 exposure, but avoid concentration in areas vulnerable to liquidity events

Oversight, Disclosure, and Controls

• Maintain price-challenge committees and independent validation of pricing models and sources
• Document all inputs, sources, and any overrides with comprehensive audit trails

Case Study (Hypothetical Example, Not Investment Advice):

An asset manager seeks to improve portfolio yield without relying entirely on Level 3 assets. They allocate a portion to less-traded US corporate bonds (Level 2), valued using matrix pricing that leverages TRACE data and dealer quotes. During the March 2020 market stress, bond spreads widen and liquidity diminishes. The manager employs swing pricing and uses RFQ platforms to manage redemptions, promoting fair value and curbing forced sales at unfavorable prices. After market stabilization, the manager reassesses exit liquidity, updates stress scenarios, and reviews portfolio sizing rules.

Resources for Learning and Improvement

• IFRS 13 and ASC 820: Official accounting standards for fair value hierarchy and valuation
• FASB, IASB, SEC comment letters: Guidance on regulatory expectations and asset classification
• Academic Literature: Research on liquidity, microstructure, and fair value methodologies
• Big Four Fair Value Guides: Practical handbooks for implementing prescribed valuation techniques
• Bank Annual Disclosures (for example, JPMorgan 10-Ks): Real world examples of Level 2 asset management and disclosures
• Market Data Vendors: Bloomberg, Refinitiv—sources for market curves, spreads, and historical trades
• Professional Education: CFA Institute, Coursera—courses on fair value, fixed income, and derivative valuation
• Industry Reports: Updates from the Alternative Investment Management Association (AIMA) or Global Association of Risk Professionals (GARP)

FAQs

What are Level 2 assets in accounting standards?

Level 2 assets are valued using observable, but indirect, market inputs such as yield curves, credit spreads, and broker quotes, rather than direct trades of identical assets.

How do Level 2 assets differ from Level 1 and Level 3 assets?

Level 1 assets use direct prices in active markets, Level 2 employs observable proxies and indirect data, and Level 3 is primarily based on unobservable model inputs.

Are Level 2 assets always illiquid?

No, although Level 2 assets often have lower liquidity than Level 1, they are generally more liquid than Level 3. Liquidity varies depending on the instrument and market environment.

Can all OTC derivatives be classified as Level 2?

Not all OTC derivatives are Level 2. Simple swaps and options with observable market inputs may be Level 2, while more complex or bespoke derivatives may require Level 3 classification.

What risks are associated with Level 2 assets?

Key risks include valuation uncertainty (due to use of models and proxy data), possible liquidity stress, and price movements during market volatility.

How are Level 2 assets typically priced?

Common methods are matrix pricing, discounted cash flow with market-based curves, and option models calibrated to related traded instruments. Several data sources and ongoing validation help ensure accuracy.

What is a misconception about Level 2 assets?

A common error is equating Level 2 assets with “Level II” equity market data or assuming they are inherently illiquid. In reality, Level 2 reflects the nature of the market inputs used for valuation.

What disclosures are needed for Level 2 assets?

Institutions must describe their valuation techniques, principal inputs, and how results may change with shifts in key assumptions. Regular calibration and complete documentation are required for compliance.

How should investors manage Level 2 assets during market stress?

Actions include stress-testing, preparing for wider bid-ask spreads, phased exits, and maintaining liquidity buffers. Ongoing monitoring of dealer activity and market depth is critical.

Conclusion

Level 2 assets play an important role in modern portfolios, combining attributes of transparency and complexity between Level 1 and Level 3. They enable access to additional yield and broader diversification while remaining anchored to observable market data. However, success in managing Level 2 assets relies on careful valuation, verification of inputs, and strong risk management, especially during volatile conditions.

Understanding the details of Level 2 assets—how they are classified, valued, and used—enables informed portfolio construction, meets reporting requirements, and supports confident decision-making in changing market environments. Continuous learning and operational discipline support the effective use of Level 2 assets and help manage associated risks.