Valuing non-traded derivatives January 2, 2013 at 2:55 pm

There has been further kerfuffle over Deutsche’s handling of gap options in leveraged supersenior trades. For instance, the FT reports the remarks of a couple of accounting professors. Charles Mulford says

“I believe that the gap risk should have been adjusted to market value – consistent with the views of the former employees,” adding: “One cannot mark-to-market the upside but not the downside.”

While Edward Ketz, according to the FT,

said that in an illiquid market accounting rules still applied and if Deutsche could not determine a market price it should have taken a conservative view and discounted the value of the trade.
“The whole idea of lack of liquidity and lack of knowing what’s out there means the fair value becomes much smaller,” he said.

Leaving aside for a second the fact that few bank CFOs would give a darn what accounting professors think about valuation (for the very reasonable reason that accountants who know their OIS discounting from their DVA are rarer than hen’s teeth), these comments represent a fundamental mis-reading of the valuation process for non-traded instruments.

What is really going on is:

  • Absent a market, you have to value financial instruments using a model.
  • There is almost always a choice of models.
  • The calibration of the model – and indeed its calibratability – matters as much as the mathematics of the model itself.
  • Some models are clearly bad choices when applied to some products as they do not capture essential features of the product.
  • Some calibrations of sensible models are foolish, as they do not reflect where the hedges that will be actually used trade.
  • There is often a wide choice of sensible models with sensible calibrations. There is usually no best choice, and no unambiguous `market value’.
  • Different choices give different valuations.
  • Different quants will have different views on what is `best’. Smart derivatives traders are skeptical of the efficacy of any particular model when applied to non-traded products.
  • You will only know if the model and calibration choice you made was sensible after the product has matured and you have examined whether the hedge strategy you used captured the value that the model said was there.
  • Sometimes it is better not to model a feature using implied parameters if you do not think that it is hedgeable.
  • Taking P/L from this is aggressive, but not something most auditors would have the guts to object to.
  • Deutsche is probably fine, but if you want to know more, you should read Matt Levine.

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