The Fair Value Hierarchy and What it Means for Complex Securities Valuation
Published on 14 Aug, 2026
The fair value hierarchy determines what kind of evidence is used to value a financial instrument and how much professional judgment is required. For complex securities, understanding where an instrument sits in the hierarchy shapes everything about how it is valued, documented, and reviewed.
What the fair value hierarchy is and why it exists
The fair value hierarchy is a framework established under ASC 820 (US GAAP) and IFRS 13 (international standards) that classifies the inputs used to measure the fair value of an asset or liability into three levels. The classification is based on the observability of those inputs: how directly they can be derived from active market data versus how much they depend on the appraiser's own assumptions and models.
The hierarchy exists for a practical reason, fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Where a market price is directly observable, that price is the most reliable evidence of fair value. Where it is not, the valuation must rely on less direct evidence and the hierarchy provides a framework for categorising and disclosing how much reliance has been placed on observable versus unobservable inputs.
The hierarchy does not prescribe a valuation methodology. It classifies inputs, not techniques. A discounted cash flow model, an option pricing model, and a market comparable approach can all produce Level 2 or Level 3 conclusions depending on whether the inputs used are observable. For a detailed explanation of the valuation approaches themselves, see How Complex Securities Are Valued.
The three levels of the fair value hierarchy
Level 1: Quoted prices in active markets for identical assets or liabilities
The highest priority level. No adjustment to the quoted price is permitted.
Level 1 inputs are quoted prices in active markets for instruments that are identical to the one being valued. An active market is one in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis. The quoted price is used without adjustment, even where the holder believes the market price does not fully reflect the instrument's value.
Examples: exchange-traded equities, government bonds, exchange-traded derivatives, publicly traded debt instruments with active secondary markets.
Complex securities and Level 1: Almost no complex securities qualify for Level 1. Convertible notes, warrants issued by private companies, earnouts, and preferred equity with complex rights are all privately negotiated and illiquid. There is no active market quoting prices for identical instruments.
Level 2: Observable inputs other than quoted prices in active markets
Observable inputs that are not direct market quotes but can be derived from or corroborated by market data.
Level 2 inputs are observable but not directly quoted prices for the identical instrument. They include quoted prices for similar instruments in active markets, quoted prices for identical instruments in markets that are not active, and inputs derived from observable market data such as interest rates, yield curves, credit spreads, and implied volatility surfaces from traded options.
A valuation that uses Level 2 inputs still involves professional judgment, particularly in selecting and adjusting comparable market data for differences between the reference instruments and the instrument being valued. However, the judgment is anchored in observable market evidence rather than the appraiser's own assumptions.
Examples: interest rate swaps valued using observable yield curves, corporate bonds valued using quoted spreads for similar issuers, warrants on publicly traded companies valued using the company's own implied volatility.
Complex securities and Level 2: Some complex securities qualify for Level 2 where the underlying asset is publicly traded and market-observable inputs are available. A warrant on a publicly listed company can typically be valued using the company's observable stock price and implied volatility. A convertible note issued by a public company may qualify if the credit spread is observable from traded comparable instruments.
Level 3: Unobservable inputs reflecting the entity's own assumptions
The lowest priority level. Inputs are developed by the appraiser based on the best available information about what market participants would use.
Level 3 inputs are unobservable. They are used when observable market data is not available for the inputs required to value the instrument. The appraiser develops these inputs using the best available information, including the company's own financial data, management projections, industry data, and professional judgment about what a hypothetical market participant would assume.
Level 3 does not mean the valuation is unreliable or unsupported. It means the evidence base is less directly observable than Level 1 or Level 2, and that the appraiser's assumptions play a larger role in the concluded value. The documentation burden and auditor scrutiny are correspondingly higher.
Examples: convertible notes issued by private companies, warrants and options on private company equity, earnouts and contingent consideration, preferred equity with complex liquidation rights, structured products with no comparable market transactions.
Complex securities and Level 3: The majority of complex securities issued by or held by private companies are Level 3. The underlying stock price is not observable, the volatility must be estimated from comparable public companies, and probability weights for milestone-based payoffs are entirely the appraiser's judgment. All of these are unobservable inputs.
Why complex securities are almost always Level 2 or Level 3
The Level 1 classification requires an active market quoting prices for the identical instrument. Complex securities fail this test by definition. They are privately negotiated, bespoke in their terms, and illiquid. No two convertible notes, warrants, or earnout structures are identical, and there is no exchange on which they trade.
The Level 2 classification requires that the key valuation inputs be observable from market data. This is possible for some complex securities where the underlying asset is publicly traded. A warrant on a listed company can use the company's observable stock price and the implied volatility derived from its traded options. A convertible bond issued by a public company can use observable credit spread data. These instruments may qualify as Level 2.
For private company instruments, the key inputs are typically not observable. The current stock price must be independently determined through a separate valuation. Volatility must be estimated from comparable public companies rather than from the company's own trading history. Probability weights for earnout milestones are the appraiser's own judgment. The instrument is therefore Level 3.
Level 3 is the norm for private company complex securities. This is not a deficiency in the valuation. It reflects the nature of the instruments. What it requires is that the appraiser's assumptions be rigorously derived, explicitly documented, and capable of withstanding auditor scrutiny. The quality of a Level 3 valuation is judged by the rigour of the assumption derivation, not by the level classification itself.
What ASC 820 and IFRS 13 require from a valuation perspective
Both standards define fair value as an exit price: the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. This has two practical implications for how complex securities are valued.
First, the valuation must reflect what a hypothetical market participant would pay, not what the holder believes the instrument is worth. Management projections, internal synergy estimates, and company-specific assumptions must be adjusted to reflect market participant assumptions where they differ. This is a judgment-intensive step for Level 3 instruments where no market participant data is directly observable.
Second, both standards require the valuation to reflect the principal market for the instrument: the market with the greatest volume and level of activity. For most complex securities issued by private companies, no principal market exists. The valuation must therefore reflect a hypothetical transaction in the most advantageous market available, which is determined based on the instrument's characteristics and the markets in which it could reasonably be sold.
A third requirement specific to Level 3 instruments is calibration. Where a recent transaction involving the instrument or a comparable instrument has occurred, the valuation model should be calibrated to reproduce that transaction price. A model that cannot reproduce an observed transaction without adjustment is a signal that the model structure or inputs require review.
What Level 3 classification means for the valuation process
Level 3 classification has four practical consequences for how a complex securities valuation is conducted and reviewed.
| IMPLICATION | WHAT IT MEANS IN PRACTICE |
|---|---|
| Higher documentation burden | Every unobservable input must be explicitly documented: its derivation, the data sources used, the judgment applied, and why the assumption reflects what a market participant would use. A Level 3 valuation report is substantially more detailed than a Level 2 one. Auditors expect to be able to trace every input back to its source |
| Sensitivity analysis required | Because unobservable inputs carry more uncertainty than observable ones, the valuation report should include sensitivity analysis showing how the fair value conclusion changes as key inputs vary. This allows auditors and management to understand which assumptions drive the result most significantly and to assess whether the conclusion is reasonable across a range of plausible inputs |
| Greater auditor scrutiny | Auditors apply more intensive review to Level 3 valuations because the inputs are not independently verifiable from market data. The auditor will assess the reasonableness of each key assumption, review the comparable data used to derive unobservable inputs, and may engage their own valuation specialists to review the methodology and conclusions |
| Independence is essential | Where inputs are unobservable and cannot be independently verified from market data, the independence of the appraiser becomes the primary quality signal. An internal valuation of a Level 3 instrument carries significantly less credibility with auditors than one produced by a credentialed independent appraiser. The independence standard is not reduced because the inputs are unobservable; it is more important |
How instruments move between levels
An instrument's level classification is not fixed. It reflects the observability of inputs at a specific measurement date. Changes in market conditions, the issuer's status, or the availability of market data can move an instrument between levels from one reporting period to the next.
1. Movement up the hierarchy
Level 3 to Level 2
An instrument moves from Level 3 to Level 2 when previously unobservable inputs become observable. The most common example is a private company that completes an IPO: its stock price becomes observable, volatility can be derived from traded options, and instruments that were previously Level 3 may qualify as Level 2. A secondary market for comparable instruments emerging in the same sector can have a similar effect.
2. Movement down the hierarchy
Level 2 to Level 3
An instrument moves from Level 2 to Level 3 when previously observable inputs become unobservable. Market dislocation, where trading in reference instruments becomes inactive or unreliable, is the most common cause. During periods of significant market stress, credit spreads and volatility data that were previously observable from active markets may no longer be available, pushing instruments down to Level 3.
Level transfers are disclosed, not hidden. Transfers between levels are reported in the financial statements and are subject to auditor review. A transfer from Level 2 to Level 3 following a period of market stress, or from Level 3 to Level 2 following an IPO, should be documented and explained. Unexplained or poorly documented level transfers attract scrutiny.
Practical implications for finance teams holding or issuing complex securities
Understanding where instruments sit in the fair value hierarchy helps finance teams manage the valuation process more effectively and anticipate what auditors will require.
Identify the level early
The level classification should be determined at the time the instrument is first recognised, not at the first audit. Knowing in advance that an instrument is Level 3 allows the appropriate valuation process to be commissioned with enough lead time to meet reporting deadlines
Commission independent valuations for Level 3 instruments
Internal valuations of Level 3 instruments are unlikely to satisfy auditors. The independence of the appraiser and the rigour of the input derivation are the primary quality signals in the absence of observable market data. Engaging a credentialed independent appraiser is not optional for most Level 3 instruments in an audited reporting context
Retain documentation at each measurement date
Level 3 valuations must be supported by contemporaneous documentation. Reconstructing the input derivation after the fact (even if the concluded value was correct) creates audit risk. The documentation should be produced as part of the valuation engagement, not assembled afterward
Monitor for level transfers
Where market conditions change materially (an IPO, a market dislocation, a significant change in the issuer's financial position), the level classification should be reassessed. A transfer that is not identified and disclosed creates a reporting gap
Plan for sensitivity analysis
Level 3 valuations require sensitivity analysis as part of the documentation. This is not an afterthought, the sensitivity analysis should be designed as part of the model and not added at the end. For more on what audit-ready complex securities valuations require, see Producing Audit-Ready Complex Securities Valuations: What Finance Teams Need to Know.
Key Takeaways
- The fair value hierarchy classifies valuation inputs into three levels based on observability. Level 1 uses quoted market prices, Level 2 uses observable but indirect inputs, and Level 3 uses unobservable inputs developed by the appraiser
- Both ASC 820 and IFRS 13 define fair value as an exit price reflecting market participant assumptions. For Level 3 instruments, this means management projections and company-specific assumptions must be adjusted to reflect what a hypothetical market participant would use, and the model must be calibrated against any available transaction evidence.
- Complex securities are almost always Level 2 or Level 3. They are privately negotiated, bespoke, and illiquid: which means no active market quotes prices for identical instruments
- Private company complex securities are typically Level 3. The stock price, volatility, and probability weights required to value them are not directly observable from market data
- Level 3 classification increases the documentation burden, requires sensitivity analysis, attracts more intensive auditor scrutiny, and makes appraiser independence more important rather than less
- Instruments can move between levels as market conditions change. An IPO can move an instrument from Level 3 to Level 2; market dislocation can move it in the opposite direction. Level transfers must be identified, documented, and disclosed
Related Reading in This Series
- What Are Complex Securities? Types, Examples, and Valuation Challenges
- How Complex Securities Are Valued: An Overview of Valuation Approaches
- Why Complex Securities Require Independent Valuation
- Producing Audit-Ready Complex Securities Valuations: What Finance Teams Need to Know
This article is part of a series on complex securities valuation and is intended for general informational purposes only. It does not constitute legal, tax, financial, or accounting advice. The description of the fair value hierarchy presented here focuses on its implications for the valuation process and is not a comprehensive treatment of ASC 820 or IFRS 13. Both standards are subject to interpretation and amendment. Companies should obtain qualified auditors and a credentialed independent valuation professional for any complex securities valuation engagement. This article does not create an attorney-client or appraiser-client relationship.