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

Valuation of Derivatives: The importance of getting it right

This article appeared in The Edge (Malaysia) on 16 July 2011

The valuation of derivatives has become a common discussion theme since the financial crisis. Complex and structured derivatives like credit debt obligations (CDO) that were believed to be priced at “fair values” barely came close to their realisable values when unwound in the extremely volatile market of 2007 and 2008.
Prior to the crisis, it was not a common practice for the clients of investment banks (e.g. corporations and fund management companies) to question or challenge the valuation of derivatives that were done over the counter (OTC) with the banks. On the other hand, the investment banks were equipped with state of the art models to price these OTC derivatives; however they overlooked some important issues that come with complex models.

This article will zoom into some problematic areas around the valuation of OTC derivatives to illustrate how valuations can go awfully wrong if certain issues are overlooked.

§  Pricing OTC Instruments

Auditing Derivatives: Think of what can go wrong Middle Office (Valuation)

 This article appeared in the Malaysian Accounting Journal, May-June 2011

In the previous issues, we were introduced to different functions of an investment bank (the Trading Floor, P/L Control Group and Risk Management) with the focus being the auditor’s mindset in auditing derivatives in these areas – thinking of what can go wrong.

In this article I introduce the Valuation Group, also referred to as the “Independent Price Valuation” (IPV), the “Price Verification” or “Price Testing” group. The IPV function can exist within the P/L Control group or it can stand alone to maintain its independence.

The IPV function
The valuation function should not be confused with the Accounting role in the investment bank. The latter operates on a higher level in determining adherence to accounting standards in booking trades into the financial statements.

The IPV team in an investment bank reviews the value of all trades recorded by the P/L Control Group. The duty of this team is to tell management every month, if the trades in the books have “fair values”. In other words, if the bank was forced to liquidate the trades, the bank would be able to realise those values on the books. This assumption is closely connected to liquidity and we will observe later that this is a challenge for bespoke (custom-made) trades.  

Trades are normally categorised in a few groups for price verification to take place:
§  Trades which prices come straight from the market – for example shares, bonds and “flow” derivatives like futures. The only focus here is that the products are recorded at the correct market prices taken at the end of day with appropriate bids or offer rates, depending on the positions – long or short.
§  Trades which are not as liquid – for example illiquid bonds and derivatives (traded over-the counter) written on illiquid credit names where market prices are not always readily available.
§  Bespoke trades – trades that are highly customised for the individual customer and traded over the counter. Most of these are structured derivative deals.

The IPV group will break down each trade by its parameters and assesses if the parameters are accurate and observable in the market.

What can go wrong?