Exelon 2014 Annual Report Download - page 201

Combined Notes to Consolidated Financial Statements—(Continued)
(Dollars in millions, except per share data unless otherwise noted)
Exelon may utilize fixed-to-floating interest rate swaps, which are typically designated as fair value hedges, as a means to achieve
its targeted level of variable-rate debt as a percent of total debt. In addition, the Registrants may utilize interest rate derivatives to
lock in interest rate levels in anticipation of future financings. These interest rate derivatives are typically designated as cash flow
hedges. Exelon determines the current fair value by calculating the net present value of expected payments and receipts under the
swap agreement, based on and discounted by the market’s expectation of future interest rates. Additional inputs to the net present
value calculation may include the contract terms, counterparty credit risk and other market parameters. As these inputs are based on
observable data and valuations of similar instruments, the interest rate swaps are categorized in Level 2 in the fair value hierarchy.
See Note 12—Derivative Financial Instruments for further discussion on mark-to-market derivatives.
Deferred Compensation Obligations. The Registrants’ deferred compensation plans allow participants to defer certain cash
compensation into a notional investment account. The Registrants include such plans in other current and noncurrent liabilities in
their Consolidated Balance Sheets. The value of the Registrants’ deferred compensation obligations is based on the market value of
the participants’ notional investment accounts. The notional investments are comprised primarily of mutual funds, which are based
on observable market prices. However, since the deferred compensation obligations themselves are not exchanged in an active
market, they are categorized as Level 2 in the fair value hierarchy.
Additional Information Regarding Level 3 Fair Value Measurements
Mark-to-Market Derivatives (Exelon, Generation, ComEd). For valuations that include both observable and unobservable inputs, if
the unobservable input is determined to be significant to the overall inputs, the entire valuation is categorized in Level 3. This
includes derivatives valued using indicative price quotations whose contract tenure extends into unobservable periods. In instances
where observable data is unavailable, consideration is given to the assumptions that market participants would use in valuing the
asset or liability. This includes assumptions about market risks such as liquidity, volatility and contract duration. Such instruments are
categorized in Level 3 as the model inputs generally are not observable. Exelon’s RMC approves risk management policies and
objectives for risk assessment, control and valuation, counterparty credit approval, and the monitoring and reporting of risk
exposures. The RMC is chaired by the chief risk officer and includes the chief financial officer, corporate controller, general counsel,
treasurer, vice president of strategy, vice president of audit services and officers representing Exelon’s business units. The RMC
reports to the Exelon Board of Directors on the scope of the risk management activities and is responsible for approving all valuation
procedures at Exelon. Forward price curves for the power market utilized by the front office to manage the portfolio, are reviewed
and verified by the middle office, and used for financial reporting by the back office. The Registrants consider credit and
nonperformance risk in the valuation of derivative contracts categorized in Level 2 and 3, including both historical and current market
data in its assessment of credit and nonperformance risk by counterparty. Due to master netting agreements and collateral posting
requirements, the impacts of credit and nonperformance risk were not material to the financial statements.
Disclosed below is detail surrounding the Registrants’ significant Level 3 valuations. The calculated fair value includes marketability
discounts for margining provisions and other attributes. Generation’s Level 3 balance generally consists of forward sales and
purchases of power and natural gas, coal purchases, certain transmission congestion contracts, and project financing debt.
Generation utilizes various inputs and factors including market data and assumptions that market participants would use in pricing
assets or liabilities as well as assumptions about the risks inherent in the inputs to the valuation technique. The inputs and factors
include forward commodity prices, commodity price volatility, contractual volumes, delivery location, interest rates, credit quality of
counterparties and credit enhancements.
For commodity derivatives, the primary input to the valuation models is the forward commodity price curve for each instrument.
Forward commodity price curves are derived by risk management for liquid locations and by the traders and portfolio managers for
illiquid locations. All locations are reviewed and verified by risk management considering published exchange transaction prices,
executed bilateral transactions, broker quotes, and other observable or public data sources. The relevant forward commodity curve
used to value each of the derivatives depends on a number of factors, including commodity type, delivery location, and delivery
period. Price volatility varies by commodity and location. When appropriate, Generation discounts future cash flows using risk free
interest rates with adjustments to reflect the credit quality of each counterparty for assets and Generation’s own credit quality for
liabilities. The level of observability of a forward commodity price is generally due to the delivery location and delivery period. Certain
delivery locations including PJM West Hub (for power) and Henry Hub (for natural gas) are more liquid and prices are observable for
up to three years in the future. The observability period of volatility is generally shorter than the underlying power curve used in
option valuations. The forward curve for a less liquid location is estimated by using the forward curve from the liquid location and
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