Wednesday, August 3, 2011

Valuation of derivatives: So what do we do?

This article appeared in The Edge (Malaysia) on 24 July 2011
In the previous article, we identified the need to pay attention to some valuation aspects of derivatives as derivative prices can easily go the other way if certain aspects are not taken care of. This article will present some possible approaches and best practises to help in addressing the valuation issue.
§   Independent Valuation Department
Institutional investors are now much more mindful of what constitutes best practice in terms of governance and risk management. Consequent to this realisation, there is a growing necessity to include an independent valuation function within financial institutions. More and more financial institutions now see the need to have their own independent pricing team. This team is “independent” as they are required to report directly to the top management of the firm. Practically, the team gathers all trades on a monthly basis, prices them again using market standard methodologies, independently from the trading desk and controllers, and report variances to top management.
Each derivatives contract or transaction will require very specific inputs such as interest rates, underlying asset values, correlation, and redemption dates. Once these properties are put through the relevant models, a fair value can be derived and distributed to management to form the daily or monthly valuation. Also built into the models are a range of sensitivity measures to measure the sensitivities of the product to the underlying asset values (delta and gamma), market volatility (vega) , interest rates (rho) and time (theta).
The benefit of this approach is that the financial institution has an understanding of the financial engineering needed to run the calculations in-house rather than just relying on third partly valuations. In fact this method is highly transparent compared to getting an external independent value services that may just aggregate prices from individual vendors and provide no input on method used for valuation or any working behind the calculations.
This team will be expected to look into pricing issues that we discussed in the previous article like counterparty risk valuation, issues related with complex model pricing and  bespoke structure features.
 §  Management’s involvement in key inputs to valuation
It is essential for managers to get very involved in valuation of financial products, in order to have knowledge and review the important aspects on a regular basis.
For example, to control calibration issues, there must be a control procedure over calibration of models.
The pricing model must be user-friendly enough to enable the manager to view all the pricing parameters so that the manager can assess which parameters drive the valuations. For example, if a manager were to look at a trade, he should be able not just to look at the discount rate but also to dwell into the yield curve used to price the instrument. If options are involved, he should be able to assess the volatility surface. He should also be able to see the last calibration date of the model.
For subjective and judgemental parameters, for example prepayment rates for asset backed securities, there must be a set procedure to enable stress testing on all possible scenarios to evaluate how sensitive this parameter is in all market conditions.
This way, managers will be able to understand the tolerance levels within the products and how they fare in diverse market environments.
§  External valuation services
If the firm does not have the expertise in house, then getting an outside vendor may be the second best choice. Here the quality of the vendor must be assessed. His track record as well as how established he is in the market is critical to ensure future support. Quality and transparency of the valuations itself is also important; valuation reports should give information about the price and all the calculation methods, assumptions and subjectivities involved. Also useful is commentary on how the monthly valuations have fared compared to the previous valuations. It will be even better if the independent valuations are compared with other valuations provided by rating agencies and the institution’s counterparties with reasons and insights.
Market players are not keen to repeat the mistakes that brought on the financial crisis in 2007. Valuations of derivatives are now stressed upon to get it right, right from the start. Even when it is all well and good, managers cannot afford to turn their backs on the numbers and assume that all is well. In today’s rapid markets, we never know what is around the corner.

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