Morgan Stanley 2009 Annual Report Download - page 142

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
that impact the valuation of MARS are independent external market data, the maximum rate, quality of
underlying issuers/insurers and evidence of issuer calls. MARS are generally categorized in Level 2 as the
valuation technique relies on observable external data. The majority of SLARS are generally categorized
in Level 3 of the fair value hierarchy.
Corporate Equities.
•Exchange-Traded Equity Securities. Exchange-traded equity securities are generally valued based on quoted
prices from the exchange. To the extent these securities are actively traded, valuation adjustments are not applied
and they are categorized in Level 1 of the fair value hierarchy; otherwise, they are categorized in Level 2.
Derivative and Other Contracts.
• Listed Derivative Contracts. Listed derivatives that are actively traded are valued based on quoted
prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Listed derivatives that
are not actively traded are valued using the same approaches as those applied to OTC derivatives; they are
generally categorized in Level 2 of the fair value hierarchy.
•OTC Derivative Contracts. OTC derivative contracts include forward, swap and option contracts related to
interest rates, foreign currencies, credit standing of reference entities, equity prices or commodity prices.
Depending on the product and the terms of the transaction, the fair value of OTC derivative products can
be either observed or modeled using a series of techniques, and model inputs from comparable
benchmarks, including closed-form analytic formulas, such as the Black-Scholes option-pricing model,
and simulation models or a combination thereof. Many pricing models do not entail material subjectivity
because the methodologies employed do not necessitate significant judgment, and the pricing inputs are
observed from actively quoted markets, as is the case for generic interest rate swaps, certain option
contracts and certain credit default swaps. In the case of more established derivative products, the pricing
models used by the Company are widely accepted by the financial services industry. A substantial
majority of OTC derivative products valued by the Company using pricing models fall into this category
and are categorized within Level 2 of the fair value hierarchy.
Other derivative products, including complex products that have become illiquid, require more judgment
in the implementation of the valuation technique applied due to the complexity of the valuation
assumptions and the reduced observability of inputs. This includes derivative interests in certain
mortgage-related CDO securities, basket credit default swaps, CDO-squared positions and certain types
of ABS credit default swaps where direct trading activity or quotes are unobservable. These instruments
involve significant unobservable inputs and are categorized in Level 3 of the fair value hierarchy.
Derivative interests in complex mortgage-related CDOs and credit default swaps, for which observability
of external price data is extremely limited, are valued based on an evaluation of the market and model
input parameters sourced from similar positions as indicated by primary and secondary market activity.
Each position is evaluated independently taking into consideration the underlying collateral performance
and pricing, behavior of the tranche under various cumulative loss and prepayment scenarios, deal
structures (e.g., non-amortizing reference obligations, call features) and liquidity. While these factors may
be supported by historical and actual external observations, the determination of their value as it relates to
specific positions nevertheless requires significant judgment.
For basket credit default swaps and CDO-squared positions, the correlation input between reference
credits is unobservable for each specific swap and is benchmarked to standardized proxy baskets for
which correlation data are available. The other model inputs such as credit spread, interest rates and
recovery rates are observable. In instances where the correlation input is deemed to be significant, these
instruments are categorized in Level 3 of the fair value hierarchy.
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