Under fair value conditions, applying a DLOM creates an opportunity to make risk-free profits (or arbitrage) between the marketable and nonmarketable security, which can lead to significant distortions from a financial reporting perspective.
One can demonstrate this result more formally by considering the nonmarketable security to be a derivative of the underlying marketable security.
The payoff of the nonmarketable security occurs at the end of the nonmarketable period and is equal to the fair value of the marketable security.
Because the cost of hedging the nonmarketable security is the current price of the marketable security, it follows that applying a DLOM creates an opportunity to make risk-free profits, or arbitrage.
Assume an investor holds a nonmarketable security valued at $80, and that the security's otherwise identical marketable counterpart is valued at $100 (i.
In addition, the nonmarketable security may be contractually precluded from being used as collateral, or the holders prohibited from hedging their position.
After two years, the fair value of the nonmarketable security will equal that of the marketable security.
A nonmarketable security is equivalent to a marketable security less the ability to sell the security over the nonmarketable period.
Marketability equivalence put option, where the nonmarketable security is equivalent to the marketable security less a put option with the length of the nonmarketable period and an exercise price equal to the fair value of the marketable security at the end of tire nonmarketable period.