Valuing Independence in Derivative Valuations
November 16, 2010
Fund managers are moving to get independent values on over-the-counter derivatives, rather than relying on their broker-dealers.
Just in the nick of time. “The financial crisis showed the fallacies of being dependent strictly on counterparties who had a vested interest in how the assets were valued,” says Andy Nybo, director of derivatives research for TABB Group, a New York based research firm. “Coupled with the growing demands of investors and regulatory requirements for transparency, asset managers are turning to an array of fund administrators, valuation specialists and software vendors’’ to price derivatives such as credit default and interest-rate swaps.
In a recently published research report, Nybo estimates that fund managers will account for about 30 percent of the $249 million which financial firms will spend in tapping valuation providers in 2010. By 2013 that figure will rise to about thirty percent of the $294 million.
“Although fund managers are in need of independent valuations their budgetary constraints will likely translate into far less spending than their larger sell-side counterparts,” says Nybo
The trend toward independent pricing is also gaining momentum due to the explosive growth of trading of over-the-counter derivatives by traditional asset managers and pension plans. Their appeal is no longer limited to the more aggressive hedge funds and some asset managers have hundreds or even thousands of derivative trades on their books they must value daily.
Valuing OTC derivatives is no easy task. The opaque and complex instruments that are linked to the movement of equities, interest rates, currencies and commodities are not traded on exchanges so there is no consensus on just what the price should be. That leaves fund managers scrambling to find come up with answers.
And not all OTC derivatives are alike. “In developing a pricing model for variance swaps—contracts in which counterparties agree to make payments based on the realized variance over time of a stock index or individual price – fund managers must make assumptions about the distribution of rates of return in the future,” explains Dwight Grant, a managing director of Duff & Phelps, a financial advisory and investment banking firm. “By contrast, correlation swaps are far more difficult to price because data is less readily available and correlations tend to be less stable over time than variances.”
Making matters more complicated for fund managers are the additional layers of disclosure which the U.S. financial reform bill passed in July – and other accounting regulations require. Currently, fund managers must also be able to comply with so-called fair value accounting regulations which require that they disclose just what methodologies and inputs they used to value all of their assets. That includes OTC derivatives.
Under the new financial reform legislation, “fund managers would be required to clear what are called ‘standardized’ contracts with clearinghouses which in turn will need to publish the settlement price on a daily basis and value those assets,” says Vinod Jain, managing consultant for the OTC derivatives practice at Headstrong, a New York based financial services consultancy. “The clearinghouses will then forward those prices to their clearing members so that sufficient collateral can be posted.”
