Enterprise Data Management
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Enterprise Pricing Policies Crucial to Risk Mitigation
March 16, 2009
With bad valuations of complex financial instruments commonly cited as a key factor behind the credit crisis, valuation experts are stressing the importance of consistent, enterprisewide pricing policies in mitigating risk.
A new study, authored by analytics software provider NumeriX and Credit Market Analysis (CMA), a derivatives pricing and market data specialist, points to the need for transparency when valuing assets such as over-the-counter, asset-backed and mortgage-backed securities.
Financial modeling systems from vendors such as NumeriX digest data from multiple external sources and have built-in controls and audit capabilities. CMA, acquired by CME Group last year, says its pricing data is based on a "buy-side consensus" model that seeks to eliminate dealer biases by using observed, tradable quotes.
While organizations likely will continue to invest in proprietary or third-party pricing models--the first step toward a valuation policy--New York-based NumeriX says they must also adopt a "codified and repeatable" methodology so they can create a front-to-back-office audit trail. That methodology would ideally be created by a pricing committee consisting of business unit, finance, compliance, legal and risk management staff.
"A consistent pricing policy means that different departments use the same financial models and data inputs to value the same financial contracts," explains NumeriX president Steve O'Hanlon. "The challenge has been that multiple financial models were used for the same instrument and even when the same model was used it was not calibrated in the same fashion because different inputs were adopted."
To ensure consistency across the firm, a model has to maintain the same view of the data within all internal applications and business lines. That eliminates reporting discrepancies and enables the back-testing strategies critical to bringing new financial contracts to market, says CMA chief executive Laurent Paulhac.
The merits of an enterprise pricing policy extend beyond complying with Financial Accounting Standard 157, which established a three-tiered methodology and documentation process for valuing securities.
"If a front office is using a different recovery assumption for a credit derivative contract than other parts of the organization, it will not only impact the value of the position but also the default risk," says Mark Traudt, CTO of Quantifi, a Summit, N.J.-based provider of credit derivatives pricing and risk analytics software. "That could result in very different enterprisewide views of potential exposure in the event of a default."
Because margining requirements to meet capital adequacy rules are based on various stress tests, including default scenarios, any differences in default risk will ultimately need to be reconciled, says Traudt.
Particularly on the buy side, many firms have work to do before they reach consistent pricing strategies. "Hedge funds are still in the early stages of devising a pricing policy and often rely on counterparty or broker-dealer quotes or use their third-party administrators," says Ron McGann, senior consultant with Citisoft, a buy-side consultancy in Boston. For OTC contracts, that approach can pose problems in determining collateral requirements.
Joseph Pimbley, managing director of financial engineering at Duff & Phelps, a New York-based financial advisory, says that even in a best-case scenario, "one group may have a detailed, written pricing policy while another follows its own [unwritten] policy."
Pimbley recommends that firms that have pricing committees put risk managers on equal footing with trading desks and finance departments when choosing a model. In some cases, "the finance group may want to write down the assets, while the trading desk, which has a short-term transactional viewpoint and limited understanding of financial models, doesn't want to report any losses," says Pimbley. "The skilled risk manager must develop risk models embedded in-and consistent with-the company's enterprisewide financial model and inputs."
