Morgan Stanley 2009 Annual Report Download - page 129

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
inputs that market participants would use in pricing the asset or liability developed based on market data obtained
from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s
assumptions about the assumptions other market participants would use in pricing the asset or liability developed
based on the best information available in the circumstances. The hierarchy is broken down into three levels
based on the observability of inputs as follows:
• Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that the
Company has the ability to access. Valuation adjustments and block discounts are not applied to Level 1
instruments. Since valuations are based on quoted prices that are readily and regularly available in an
active market, valuation of these products does not entail a significant degree of judgment.
• Level 2—Valuations based on one or more quoted prices in markets that are not active or for which all
significant inputs are observable, either directly or indirectly.
• Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value
measurement.
The availability of observable inputs can vary from product to product and is affected by a wide variety of
factors, including, for example, the type of product, whether the product is new and not yet established in the
marketplace, the liquidity of markets and other characteristics particular to the transaction. To the extent that
valuation is based on models or inputs that are less observable or unobservable in the market, the determination
of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in
determining fair value is greatest for instruments categorized in Level 3.
The Company uses prices and inputs that are current as of the measurement date, including during periods of
market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for
many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2
to Level 3 (see Note 4). In addition, a downturn in market conditions could lead to further declines in the
valuation of many instruments.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In
such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement
falls in its entirety is determined based on the lowest level input that is significant to the fair value
measurement in its entirety.
Valuation Techniques. Many cash and OTC contracts have bid and ask prices that can be observed in the
marketplace. Bid prices reflect the highest price that a party is willing to pay for an asset. Ask prices represent
the lowest price that a party is willing to accept for an asset. For financial instruments whose inputs are based on
bid-ask prices, the Company does not require that the fair value estimate always be a predetermined point in the
bid-ask range. The Company’s policy is to allow for mid-market pricing and adjusting to the point within the
bid-ask range that meets the Company’s best estimate of fair value. For offsetting positions in the same financial
instrument, the same price within the bid-ask spread is used to measure both the long and short positions.
Fair value for many cash and OTC contracts is derived using pricing models. Pricing models take into account
the contract terms (including maturity) as well as multiple inputs, including, where applicable, commodity prices,
equity prices, interest rate yield curves, credit curves, correlation, creditworthiness of the counterparty, option
volatility and currency rates. Where appropriate, valuation adjustments are made to account for various factors
such as liquidity risk (bid-ask adjustments), credit quality and model uncertainty. Credit valuation adjustments
are applied to both cash instruments and OTC derivatives. For cash instruments, the impact of changes in the
Company’s own credit spreads is considered when measuring the fair value of liabilities and the impact of
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