Information Risk and Fair Value: An Examination of Equity Betas and Bid-Ask Spreads

Finance theory suggests that information risk―that is, the uncertainty regarding valuation parameters for an underlying asset―is reflected in firms’ equity betas and the information asymmetry component of bid-ask spreads. We empirically examine these predictions for a sample of large U.S. banks, exploiting recent mandatory disclosures of financial instruments designated as fair value level 1, 2, and 3, which indicate progressively more illiquid and opaque financial instruments. Consistent with predictions, results reveal that portfolios of level 3 financial assets have higher implied betas and lead to larger bid-ask spreads relative to those designated as level 1 or level 2 assets. Both results are consistent with a higher cost of capital for banks holding more opaque financial assets, as reflected by the level 3 fair value designation. Key Terms: banks, risk, fair value, financial instruments JEL Classification: G12, G14, G21, M41 Acknowledgements: We thank the following for useful discussions and comments: Robert Merton, Devin Shanthikumar, Irem Tuna, and Florin Vasvari, as well as seminar participants from the London Business School. * Contact author: Morgan Hall 365, Boston, MA, 02163. [email protected]. Phone 617-495-6368.