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Consistency in Valuations is Vital for Dealing with Derivatives, Says Lepus and Asset Control

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Accurate documentation surrounding valuations is growing in importance in the area of complex derivatives, according to a recent panel discussion held by Lepus Consulting and sponsored by Asset Control. The panel, which included representatives from a number of Wall Street banks and US mutual funds such as TIAA-CREF, agreed that knowing the ultimate parent for derivatives is key to correct valuation. It is as important as understanding the difference between the obligor and the third party for compliance purposes, one panellist explained.

Understanding counterparty exposure is complicated for credit derivatives in particular because tranches are tied to indices and therefore there is a different volatility for the investment and the index. The focus on ‘time to market’ for these products also complicates matters as the use of Excel is encouraged because of this requirement for speedy delivery. This needs to be more adequately balanced with controls surrounding pricing and valuations in order to achieve a consistent methodology, the panel agreed.

Governance in the decision making process is critical as these instruments multiply in number and a firm must be able to juggle demands, manage expectations and trade in a way to manage risk-return tradeoffs.

One panellist talked about valuation and the role of “fair valuation committees” with cross functional representatives to determine the “best value” across the host of structured products. The quant and the accountant must both challenge assumptions in order to achieve better valuations. The firm should also document a policy and process for this, as well as determining a pricing hierarchy for vendor pricing decisions, as they may have different price options from the front office, vendors, counterparties or from other internal sources. “It’s important to have multiple sources and the middle office has a major role in setting hierarchy rules,” one panellist contended.

The panel debated the downside risk of valuations and the impact of these on order books and records. It was agreed that for transparency, there is a need to understand the risk, data issues and exceptions surrounding complex asset valuations, as well as taking responsibility for these within the firm.

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