We assume that every instrument of interest can be assigned a fair value. If the payoff stream of the instrument is ,wedenoteitsfairvalue Following GAAP accounting rules, we view the fair value as the price at which the instrument could be sold “in an orderly transaction”. For instruments traded in a market, fair values can be read off market prices. For nontraded instruments, such as loans, fair values have to be constructed from the payoffs of comparable instruments. The fair values of fixed income instruments exhibit a low-dimensional factor structure. In particular, the overwhelming majority of movements in bond prices is due to the “overall level” of interest.
