Market Valuation

The policy of marking to market all trading positions, at least as often as the close of business each
day, as per the G‐30’s Recommendation 2, constitutes the essential foundation for measuring
trading risk because of three primary reasons. First, without a nearly continuous marking to market,
it would be possible that ineffective hedging strategies would not be recognized until long after
being put in place. Second, the analysis of revenue will yield insight only if the revenue fi gures being
analyzed are tied to genuine changes in value. Third, in measuring the risk exposure to market
moves, it is far easier to make good judgments about possible short‐term moves than it is about
longer‐term moves. But if trades are not revalued frequently, it becomes necessary to measure risk
exposure over longer periods.

When highly liquid external prices are available for marking a position to market, then the issues
involved in performing the mark are largely operational. An example might be a position in spot
foreign exchange (FX) for the dollar versus Japanese yen. This is a market for which quotations are
readily available on trading screens, with market conventions that ensure that fi rms posting prices
are prepared to actually deal in reasonable size at these prices. Quotations for mark‐to‐market
purposes can be captured elec tronically from trading screens or entered by hand and later checked
against printouts from screens the choice should be based on the operational cost versus error rate
and the cost of correcting errors. Another example would be a position in a well‐traded stock or
exchange‐traded futures option for which the last price at which an actual trade occurred is readily
available from an exchange ticker.

For many positions, mark‐to‐market pricing is not this straightforward. Either the market itself does
not have this type of liquid quote available or the size of the position held is so large that closing it
out might impact the market. The price at which the position can be exited will be uncertain to some
degree. In such cases, two interrelated questions must be asked:

1. How should a most likely exit price be arrived at?

2. Should some markdown of the price be used to account for the uncertainty and, if so, how
should the amount of reserve be determined?

Establishing the most likely exit price may require a model to create a mark based on more readily
available prices of other instruments. Models can range from very simple computations, such as the
interpolation of an illiquid two‐and‐a‐half‐year bond from prices on more liquid two‐ and three‐year
bonds, to complex theoretical constructions. A discussion of how to use models in the marking
process and how to establish reserves against the associated uncertainty can be found in Chapter 8 .

What if price quotes are available, but are not suffi ciently liquid for a readily agreed‐upon external
valuation? This implies that deriving the most likely exit price from these quotes requires an
understanding of the relative quality of available quotes. For each quote, questions like the following
need to be answered: Is the quote one at which the fi rm or broker providing the quote is offering to
do business, or is the quote just provided as a service to indicate where the market is believed to be
today? If the quote is an offer to do business, how large a transaction is it good for? What is the
track record of the quotation provider in supplying reliable information? Are there possible
motivations to provide misleading information in an attempt to infl uence pricing to move in a
direction that favors a quote provider’s position? How frequently are quotes updated?

With such a multiplicity of information bearing on the issue, there is no doubt that traders of an
instrument have the best judgment on determining this valuation. Their continuous contact with
other fi rms’ traders and brokers enables them to build the experience to make these judgments.
The ability to make such judgments is a major factor in determining a trader’s success, so traders
who have built a successful earnings track record can make a strong claim of having the expertise to
determine most likely exit prices.

Unfortunately, reliance on traders’ judgment raises moral hazard concerns. As discussed in Section
2.1, traders are often tempted to mislead management about position exit prices in order to infl ate
reported profi ts or to increase fl exibility in the positions they are allowed to hold. Outsiders, from
corporate risk management, corporate fi nance, or the middle offi ce, need to be involved in making
these judgments to preserve independence. However, designing mechanisms for resolving disputes
between traders and control personnel raises many diffi cult issues:

- How can control personnel obtain a suffi cient knowledge base to challenge traders’ judgments?
At a minimum, traders should be required to make public the information on which judgments
are made. This can be accomplished by insisting that quotes be sent to the fi rm in writing
(whether through trading screens, e‐mail, or fax). Alternatively, control personnel should have
the right to selectively listen in on phone conversations in which quotes are made.
- Ideally, control personnel should have a range of experience that enables them to arrive at
independent conclusions regarding quotations, perhaps even prior trading experience.
- Records should be kept of prior experience with the reliability of a particular trader’s valuations
by tracking the path of internal marks leading up to an actual purchase or sale price and noting
suspicious patterns. Control personnel should adjust their deference to trader valuations by the
degree of proven reliability.
- A trader’s ultimate weapon for bringing credibility to a valuation is to actually exit part of the
position. A recorded price narrows disputes down to the single question of whether the size of
the trade relative to the retained position is large enough to be a reliable indicator of the exit
price for the remainder.

Despite best efforts to design dispute resolution processes that balance power between traders and
control personnel, traders inevitably retain a strong advantage based on information asymmetry.
They can utilize their knowledge of a wide variety of sources of price quotes to selectively present
only those that are the most advantageous to their case. They sometimes use friendships and
exchanges of favors to infl uence other market participants to provide quotes biased toward their
valuations. Traders also often rely on an aggressive personal style and internal political power based
on their profi tability to prevail through intimidation.

To remedy this power asymmetry, some fi rms prefer to rely on more objective computations for
determining valuations, even where this reduces accuracy by lessening the role of judgment. A
typical approach would be to average the quotes obtained from a set panel of other fi rms or
brokers, perhaps discarding outliers before averaging (discarding outliers is a possible protection
against a few quotes that have been biased by friendship or favor). Changes in panel membership
should be diffi cult to make and require agreement between traders and control personnel.

A promising development toward more objective valuations for less liquid instruments is the Totem
Market Valuations service. This service is designed to share information among fi rms making
markets in less liquid products. Firms can obtain access to quotes on only those products for which
they are willing to provide quotes. Their access to quotes can be cut off if the quotes they provide
are frequently outliers, indicating either a lack of expertise or an attempt to bias quotations.
Although the extensive machinery of this process means it can make quotes available only once a
month and with a lag of a few days, it still provides a valuable check on the valuations of a fi rm’s
traders.
The following are some pitfalls to be wary of when setting up a procedure for deriving valuations
from less than fully liquid market quotes:

- Model‐derived quotes. Here is an illustration of a frequently encountered problem. You need a

valuation for a particular bond and you have a choice: either use a model to compute the value
based on observed prices of more liquid bonds with similar maturities and credit ratings or use
price quotes for the particular bond obtained from brokers. Before choosing the latter, ask the
following question: Are the brokers providing a quote specifi c to this bond or are they just
providing the output of their own model based on prices of more liquid bonds? If your external
source is model based, might you be better off using your own model? The following are some
advantages to using a model‐based external quote:
- You may be able to get model‐based quotes from several sources with the hope that errors will
average out.
- The external models are being tested by the use of the quotes by many different fi rms, so it is
more likely that objections will be raised if the model is missing something.
- It is less likely that traders will infl uence the outcome when an external source is being used.
- The quotes may become so widely used as to be a good indicator of where the market is trading.
- The primary disadvantage to using a model‐based external quote is that you may not be able to
obtain details of the model used, so it is harder to estimate potential error and build adequate
reserves for uncertainty than when using your own model.
- Revealing positions. When quotes are not available on regularly displayed screens or reports, fi
rms seeking quotes may need to make specifi c inquiries to obtain quotes. Their inquiries reveal
information about the positions the fi rm holds that can be used to the fi rm’s disadvantage by
other market participants. This is particularly true if th