Bob Park of FINCAD explains how derivative valuation and risk measurement software or services can play a cost effective role in addressing concerns of transparency.
As we slowly rise out of the financial crisis, the need for increased transparency in the valuation of derivatives is an important requirement for every financial institution – whether to improve investor confidence or to show auditors how the derivatives were valued. The call for transparency in derivatives valuation is not a new concept. Treasuries have been required to increase the transparency and clarity of their financial reporting, and financial reporting processes. These changes are mandated through various financial accounting standards such as IAS 39, FAS 133, FAS 157, or regulations such as Sarbanes-Oxley. Although the need for compliance is widely discussed, these regulations are not prescriptive on how to comply, and many are wondering if technology can be part of the solution. Most are discovering that derivative valuation and risk measurement software or services can play a cost effective role in addressing their concerns of transparency.
In addition to reducing effort and cost to comply with existing and proposed regulations, transparency can also provide information required to enhance risk management best practices. The same need for fair, independent and transparent visibility into the models, data and analytics required for transparency is crucial to successful risk measurement. Systemized transparency as part of the valuation process lends itself to better compliance and stands taller under the scrutiny of audit and investors. Furthermore, the information on valuations and risk provides valuable insight that can enhance real business performance and even competitive advantage.
Transparency in Today’s Market
Transparency reflects the idea that the more information that is disclosed about organizational activities in a more timely fashion to a wider public, the better. No matter how we define it, the fundamentals are clear – transparency requires a level of openness and visibility – whether related to a firm’s financial statements or its business practices.
While prior regulations such as Sarbanes-Oxley, IAS 39 and FAS 157, have improved organizations’ accountability, particularly with respect to their financial statements, the call for transparency is louder than before.
It remains to be seen how new regulations will take effect, the need for a common language that all stakeholders can agree on – government, regulatory boards, auditors, corporations, banks and other financial institutions, and investors is a daunting task. This common language needs to be able to deal with the complexity of the financial marketplace on a global scale. It needs to be proven, documented and clear.
One of the ways to increase the transparency of the derivatives process, for both valuation and understanding the risk, is to understand how such instruments are valued: What models and methods are used to value them? How accurate are the inputs to the valuations? What risks are involved and how are they measured? Who are the counterparties involved and what is their level of risk?
It is evident that transparency is important. But what role can technology play in order to meet existing and proposed regulations?
Technology’s Role in Transparency
To regain investor confidence and trust, corporations, banks and other financial institutions need to fully embrace transparency. This means disclosing all the facts about their financial transactions, listing all underlying assumptions, describing all relevant parameters and models used with clarity and without any confusion or guess work. A good starting point will be leveraging the advances made in derivatives valuation and risk technology.
Regulators require clear and accurate visibility into valuations and shareholders want reassurance through third party independent pricing. As a result, many organizations are now using third party valuation solutions to support their existing valuation process either to fill gaps in their systems or to obtain a secondary check against counterparty or broker quotes. Organizations need to have the ability to quickly replicate and benchmark their calculations from an explicit documentation of the implemented mathematical models.
There are a number of factors to consider when choosing valuation and risk measurement software, but full documentation is a critical one. Black box solutions are not acceptable from a transparency or risk control perspective. Providing complete transparency with comprehensive documentation and ability to view calculation methodology, formulas and examples of every function are needed. This allows users and auditors to verify and validate each and every part of a valuation.
Using a technology that doesn’t show you the details of the model, means finance professionals are working with partial information – which only leads to more mistakes down the road.
Conclusion
While we may be coming out of the crisis, we need to make sure we take the appropriate steps to prevent another one. The events of the recent past, underly the importance of providing transparency in the valuation process and ultimately understanding the risks. This means that the technology used needs to provide full documentation – disclosing the models, parameters, methodologies, and references. The benefits to finance professionals are reduced effort and cost to comply with regulations, and access to information required to enhance their risk management best practices.
Transparency in the technology gives regulators, investors and other stakeholders the information they need to be informed of how finance professionals are valuing their derivatives and gives finance professionals the tools required to make sure the same mistakes aren’t repeated.
