Financial institutions must develop internal support for complex products with the implementation of an “enterprise pricing policy”, according to a recent report by Numerix and CME Group-owned Credit Market Analysis (CMA). The report discusses the importance of consistent pricing policies for the accurate valuation of complex derivatives and structured products and outlines the implementation process for such a policy.
Steven O’Hanlon, president and chief operating officer at Numerix, explains the challenges inherent in implementation: “Financial institutions understand the crucial value of transparent pricing policies, but the obstacle is effectively implementing a consistent policy throughout the organisation to foster transparency.”
Financial institutions must therefore implement a consistent, repeatable methodology for valuing complex financial instruments and creating an audit trail from the front to back offices, say the vendors “Organisations must use industry standard analytics and proven models to create a foundation for an enterprise pricing policy. It is the only way institutions can manoeuvre the current market volatility and remain confident in their portfolios,” adds O’Hanlon.
The report explains that the credit crunch has revealed market inefficiencies and forced institutions to evaluate their participation in complex markets. This evaluation is centred on areas such as the valuation, model validation and overall risk management involved with structuring and managing portfolios.
The vendors contend that although organisations will continue to invest in software to develop better pricing strategies, they will be judging this software in certain key areas. These areas comprise: standards between trading desks, which support different asset classes; model validation for new products; and trade capture from the front to back office.
Numerix and CMA also stress the importance of data quality, both internally and externally. Laurent Paulhac, CEO of CMA, explains: “The quality of data being used within an organisation dictates its ability to create accurate and timely valuations, particularly with complex derivatives that are inherently difficult to value. If there is poor data flowing into a valuation system, there will be inaccurate data going out into the market.”
The report indicates that it is critical for financial institutions to ensure that data used internally is the same data seen by counterparties, risk managers and administrators, as well as auditors. This will eliminate inconsistencies in reporting and moreover, enable better back testing strategies that are critical to confirm accuracy before bringing instruments into the market, say the vendors. To enable this transparency, valuation providers need to ensure that services are agile enough to allow fund managers to provide accurate and timely valuations regardless of the complexity of the financial instrument, they conclude.