Morgan Stanley 2010 Annual Report Download - page 138

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
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 of the fair value hierarchy.
The Company considers 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 of the fair value hierarchy (see Note 4). In addition, a downturn in market conditions could lead to
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 instruments and OTC derivative 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 instruments and OTC derivative 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, creditworthiness of the Company, 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. Adjustments for liquidity risk adjust model derived mid-market levels of Level 2
and Level 3 financial instruments for the bid-mid or mid-ask spread required to properly reflect the exit price of a
risk position. Bid-mid and mid-ask spreads are marked to levels observed in trade activity, broker quotes or other
external third-party data. Where these spreads are unobservable for the particular position in question, spreads
are derived from observable levels of similar positions. The Company applies credit-related valuation
adjustments to its short-term and long-term borrowings (including structured notes) for which the fair value
option was elected and to OTC derivatives. The Company considers the impact of changes in its own credit
spreads based upon observations of the Company’s secondary bond market spreads when measuring the fair
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