With Brexit, global trade tensions and geopolitical risks increasing uncertainty and market volatility, pricing fixed income and derivative instruments has become very challenging. What are the 3 leading models to achieve fair value and how can Refinitiv help in this process?
- Regulatory requirements and accounting standards, such as IFRS 13 Fair Value Measurement, oblige market participants to source fair value pricing for all types of securities, including those in the non-traditional hard-to-value universe.
- Detailed assessments clearly have to be made to arrive the most suitable methodologies that lead to superior fair value.
- The evaluated pricing methodology – a hybrid approach that combines the advantages of mark-to-market and mark-to-model – eliminates the constraints of scale and lack of market pricing.
Regulatory requirements and accounting standards, such as IFRS 13 Fair Value Measurement, oblige market participants to source fair value pricing for all types of securities, including those in the non-traditional hard-to-value universe. Under IFRS 13 (and ASC 820), fair value is defined as the price received to sell the asset, in an orderly transaction, between market participants at the measurement date (i.e., an exit price). Based on the experience of the 2008 financial crisis, it has become apparent that accurate fair value is of importance to financial markets.
Global to local dynamics
While various valuation practices can be considered, combining global consistency with local expertise contributes to greater accuracy around fair value. In reality, some financial instruments tend to be hard to value because of their structural nature or actual market demand.
For the buy-side community in particular, it is a continuous challenge to balance complying with fresh regulation and maintaining investor returns. Detailed assessments clearly have to be made to arrive the most suitable methodologies that lead to superior fair value.
Mark-to-market
A mark-to-market basis is the most relevant fair value method when pricing financial instruments. However, this method requires strong two-way relationships with global market-making communities. It also requires data-driven scrutiny to ensure fair value represents consistency and transparency of broker pricing.
With respect to less liquid and high-yield instruments, the real challenge appears to thinly traded issues that can make mark-to-market pricing methodology an irrelevant practice. Financial Instruments are widely allocated in the market across diverse funds and portfolios without having an active secondary market. Furthermore, as market-makers tend to quote a price based on client demand, availability of fair value pricing becomes limited.
Mark-to-model
Pricing on a mark-to-model basis is an alternative approach for less liquid instruments. While this approach enables effective instrument pricing on a large scale irrespective of liquidity profile, it is less dependent on a market-making community. However, during periods of market volatility , the mark-to-model could have quality constraints, as input variables to the model may lag compared to market observations.
Evaluated pricing
The evaluated pricing methodology – a hybrid approach that combines the advantages of mark-to-market and mark-to-model – eliminates the constraints of scale and lack of market pricing. It has the flexibility to price instruments on a mark-to-market basis as well as the ability to utilize models to produce fair value.
Winner, winner! Read all about the #1 rated independent and transparent evaluated pricing service from Refinitiv: https://t.co/rIaf0Pf0z6 pic.twitter.com/hnJ78sGsJz
— Financial – Refinitiv (@insidefinance) December 12, 2018
As input variables are derived from market-driven comparable analysis, models are intelligently managed to maintain their significance regardless of the state of the market. This leads to superior fair value in stable market conditions as well as in volatile environments.
