What's Fair About This Value - FX & Energy Derivative Valuations

What’s Fair About This Value?
FX & Energy Derivative Valuations
Michael Corley and Phil Weeber
TEXPO – April 3-5, 2011

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Session Overview
 What is a Fair Value?
 Valuation building blocks
 Valuation of a currency forward
 Valuation of a energy derivatives
 Common valuation pitfalls
2

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Understanding Fair Value
 “Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.” (ASC 820/FAS 157)
 Exit price (transfer price, NOT termination price): The price that would be paid to
transfer a liability to another party with similar credit risk – the liability is assumed to
continue (not to be settled)
 Market participants: Buyers and sellers that are independent, knowledgeable, able, and
willing
 Transaction is a hypothetical transaction at the measurement date, considered from the
perspective of how a market participant would value the asset or the liability, considered
from the perspective of a market participant that holds the asset or owes the liability

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Understanding Fair Value (cont.)
 Similar Credit Risk: No specific methodology is prescribed in the accounting literature for
calculating Credit Value Adjustments (CVAs)
 Required inputs to calculate CVAs:
 Trade-level details:
Type of trade, notional, maturity, expected cash flows
 Portfolio content:
Required for netting
 Market data:
Interest rates, FX rates, volatility, correlations
 Credit spreads:
Probability of default, loss given default
 Credit enhancements:
Collateral
The Fair Value Continuum
Reliable/Verifiable
Subjective/Less Reliable
Level 1
Level 2
Level 3
Quoted Prices in
Valuation Techniques –
Valuation Techniques –
Active Markets
Observable Inputs
Unobservable Inputs

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Session Overview
 What is a Fair Value?
 Valuation building blocks
 Valuation of a currency forward
 Valuation of natural gas derivative
 Common valuation pitfalls
5

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Valuation Building Blocks
Discounting Future Cash Flows
 A bird in hand is better than a bird in two weeks…
1
 PV = FV
(1+i)n
– PV
Present value
– i
Discount rate for period
– n
Number of periods
– FV
Future value
 Example: If I am owed $1,000 in 2 years, what is the
present value (assume my personal discount rate is 5%) ?
PV = 1 / (1 + 0.05)2 x $1,000 = $907.03
 The big question becomes  What discount rate?
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Valuation Building Blocks
Discounting Future Cash Flows
 Markets provide rates for standard contracts and for spot starting
structures
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Valuation Building Blocks
Applying the Forward Curve
 Market data is used to construct the forward curve
 Cash flows at different points in time will be discounted at
different discount rates
6.0%
5.0%
4.0%
3.0%
2.0%
1-month LIBOR Forward Curve
1.0%
0.0%
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Session Overview
 What is a Fair Value?
 Valuation building blocks
 Valuation of a currency forward
 Valuation of energy derivatives
 Common valuation pitfalls
9

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Valuation of Forward Contracts
A Foreign Exchange Contract
 A currency forward is an agreement between two counterparties to exchange
one set amount of currency for another set amount of a different currency on
a specific date
 Key terminology:
 Notional:
The currency amounts
 Settlement Date:
The date on which the currencies will be exchanged
 Exchange rate:
The rate that will be used to convert currencies
 Forward direction:
Which counterparty is selling which currency
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