Most institutions are dissatisfied with the valuations services being provided to them, according to a recent survey by the Professional Risk Managers’ International Association (PRMIA) and OTC Valuations (OTC Val). The survey, entitled “Transparency and Independence of Derivative Valuations – Current Practices, Trends, Challenges, and Recommendations”, looks at the valuations practices within 483 firms in 77 countries.
Bob Sangha, managing director at OTC Val, explains: “The most interesting finding was the number of respondents (5%) that said they were very satisfied with their current provider. Among some of the reasons cited for the dissatisfaction with their current valuation solution were there were valuation gaps in their current solution, the solution was not transparent enough, and a lack of valuation professionals that truly understood the intricacies of an instrument and subsequently the data required to price an instrument.”
As a result of this dissatisfaction with their current providers, the majority of the respondents stated they would consider a third party valuation service vendor, says Sangha. The coverage required by these respondents includes vanilla and exotic derivatives, such as credit linked notes and other credit derivatives, equity linked notes, ABS structures, variance swaps, and inflation indexed securities.
“We conducted this survey to gain greater insight into the market perception with respect to derivative valuations, given the recent credit crisis, market turmoil, and call for greater transparency,” adds Sangha. Respondents to the survey included numerous specialties including risk practitioners, regulators responsible for derivative valuation practices, consultants and vendors working in derivatives solutions, and PRMIA members in other related professional roles, says Sangha. The majority were from western or central Europe, Asia Pacific and North America.
He believes the survey results confirm the emergence and importance of independent derivative valuations as a benchmark practice for achieving price verification and transparency. “The biggest challenges in this space are accurate valuation for vanilla and complex derivatives, finding reliable data sources to price instruments, and achieving valuation transparency,” he explains.
Recent events, for good reasons, have only corroborated the call for greater transparency and disclosure, and the importance independent derivative valuation vendors, Sangha contends. “Greater transparency and disclosure with respect to valuation methodologies, processes, market data, and assumptions employed in the valuations are drivers that will impact an institutional investor’s investment criteria. The recent credit crisis is a stark reminder of the impact mis-pricing and a lack of disclosure can have,” he adds.
According to Sangha, 78% of the respondents said independent, accurate, and transparent valuations were vital to their operations. “Three factors were cited as being the most important for the simple reason that, organisations are cognizant of the risks posed by mispricing and the inherent conflicts of counterparty marks or broker quotes. The key ingredients required to getting the numbers right are having the right models, methodologies, market data, and valuation professionals,” he continues.
Sangha believes that derivative valuation vendors are trying to make the necessary changes to keep up with the pace of instrument development, but most have been slow to implement the changes required to facilitate transparency and greater disclosure. “Their current processes were not designed to provide the level of transparency and disclosure being demanded. Derivative valuation vendors that have revised their processes will have a clear advantage in meeting this requirement,” he says.
Given the state of the financial markets, the survey says it is “unsurprising” that 28% of respondents have been experiencing the most difficulty finding fair value valuations for credit derivatives. Volatility derivatives came a close second, with 20%, while the more traditional asset classes each received around seven to 10%.
In-house solutions are used by the largest proportion of respondents for the primary source of derivatives valuations, at 45%, while third party providers ranked at 32% and counterparty marks at less than 10%. These primary valuations are largely carried out on a daily basis, at 47%, or a monthly basis, at 17%.
The average number of derivatives that require independent valuations stood at less than 25 for 28% of respondents, 100-500 for 36% and more than 1000 for 29%. Annual expenditure on independent valuations stood at: nothing for 23%, less than US$10,000 for 22%, between US$10,000 and US$100,000 for 36%, and more than US$100,000 for 19%.
Furthermore, only 17% of respondents are currently using a service provider to determine or verify derivatives portfolio valuations, and 26% are currently looking for a provider. Unfortunately for the vendor community, 41% stated they were unsure about using a provider and a further 16% said they would not outsource this function.
According to the survey, most respondents are looking to add scenario analysis, the assessment of counterparty risk, price verification through secondary sources and bid/ask data rather than mid data for valuations.
It concludes that independent derivative valuation providers will play an “increasingly significant role” in the market as a “valid risk control measure”.