Goldman Sachs 2015 Annual Report Download - page 152

THE GOLDMAN SACHS GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
The selection of a particular model to value a derivative
depends on the contractual terms of and specific risks
inherent in the instrument, as well as the availability of
pricing information in the market. For derivatives that
trade in liquid markets, model selection does not involve
significant management judgment because outputs of
models can be calibrated to market-clearing levels.
Valuation models require a variety of inputs, such as
contractual terms, market prices, yield curves, discount
rates (including those derived from interest rates on
collateral received and posted as specified in credit support
agreements for collateralized derivatives), credit curves,
measures of volatility, prepayment rates, loss severity rates
and correlations of such inputs. Significant inputs to the
valuations of level 2 derivatives can be verified to market
transactions, broker or dealer quotations or other
alternative pricing sources with reasonable levels of price
transparency. Consideration is given to the nature of the
quotations (e.g., indicative or firm) and the relationship of
recent market activity to the prices provided from
alternative pricing sources.
Level 3 Derivatives
Level 3 derivatives are valued using models which utilize
observable level 1 and/or level 2 inputs, as well as
unobservable level 3 inputs. The significant unobservable
inputs used to value the firm’s level 3 derivatives are
described below.
‰For the majority of the firm’s interest rate and currency
derivatives classified within level 3, significant
unobservable inputs include correlations of certain
currencies and interest rates (e.g., the correlation between
Euro inflation and Euro interest rates) and specific
interest rate volatilities.
‰For level 3 credit derivatives, significant unobservable
inputs include illiquid credit spreads and upfront credit
points, which are unique to specific reference obligations
and reference entities, recovery rates and certain
correlations required to value credit and mortgage
derivatives (e.g., the likelihood of default of the
underlying reference obligation relative to one another).
• For level 3 commodity derivatives, significant
unobservable inputs include volatilities for options
with strike prices that differ significantly from current
market prices and prices or spreads for certain
products for which the product quality or physical
location of the commodity is not aligned with
benchmark indices.
• For level 3 equity derivatives, significant unobservable
inputs generally include equity volatility inputs for
options that are long-dated and/or have strike prices
that differ significantly from current market prices. In
addition, the valuation of certain structured trades
requires the use of level 3 correlation inputs, such as
the correlation of the price performance of two or
more individual stocks or the correlation of the price
performance for a basket of stocks to another asset
class such as commodities.
Subsequent to the initial valuation of a level 3 derivative,
the firm updates the level 1 and level 2 inputs to reflect
observable market changes and any resulting gains and
losses are recorded in level 3. Level 3 inputs are changed
when corroborated by evidence such as similar market
transactions, third-party pricing services and/or broker or
dealer quotations or other empirical market data. In
circumstances where the firm cannot verify the model value
by reference to market transactions, it is possible that a
different valuation model could produce a materially
different estimate of fair value. See below for further
information about significant unobservable inputs used in
the valuation of level 3 derivatives.
Valuation Adjustments
Valuation adjustments are integral to determining the fair
value of derivative portfolios and are used to adjust the
mid-market valuations produced by derivative pricing
models to the appropriate exit price valuation. These
adjustments incorporate bid/offer spreads, the cost of
liquidity, credit valuation adjustments and funding
valuation adjustments, which account for the credit and
funding risk inherent in the uncollateralized portion of
derivative portfolios. The firm also makes funding
valuation adjustments to collateralized derivatives where
the terms of the agreement do not permit the firm to deliver
or repledge collateral received. Market-based inputs are
generally used when calibrating valuation adjustments to
market-clearing levels.
In addition, for derivatives that include significant
unobservable inputs, the firm makes model or exit price
adjustments to account for the valuation uncertainty
present in the transaction.
140 Goldman Sachs 2015 Form 10-K