Morgan Stanley 2010 Annual Report Download - page 154

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
assumptions and the reduced observability of inputs. This includes derivative interests in certain
mortgage-related CDO securities, certain types of ABS credit default swaps, basket credit default swaps
and CDO-squared positions (a CDO-squared position is a special purpose vehicle that issues interests, or
tranches, that are backed by tranches issued by other CDOs) 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 ABS 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, etc.) 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 or position 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; otherwise, these
instruments are categorized in Level 2 of the fair value hierarchy.
The Company trades various derivative structures with commodity underlyings. Depending on the type of
structure, the model inputs generally include interest rate yield curves, commodity underlier price curves,
implied volatility of the underlying commodities and, in some cases, the implied correlation between
these inputs. The fair value of these products is determined using executed trades and broker and
consensus data to provide values for the aforementioned inputs. Where these inputs are unobservable,
relationships to observable commodities and data points, based on historic and/or implied observations,
are employed as a technique to estimate the model input values. Commodity derivatives are generally
categorized in Level 2 of the fair value hierarchy; in instances where significant inputs are unobservable,
they are categorized in Level 3 of the fair value hierarchy.
• Collateralized Interest Rate Derivative Contracts. In the fourth quarter of 2010, the Company began
using the overnight indexed swap (“OIS”) curve as an input to value substantially all of its collateralized
interest rate derivative contracts. The Company believes using the OIS curve, which reflects the interest
rate typically paid on cash collateral, more accurately reflects the fair value of collateralized interest rate
derivative contracts. The Company recognized a pre-tax gain of $176 million in net revenues upon
application of the OIS curve within the Institutional Securities business segment. Previously, the
Company discounted these collateralized interest rate derivative contracts based on London Interbank
Offered Rates (“LIBOR”).
For further information on derivative instruments and hedging activities, see Note 12.
Investments.
• The Company’s investments include investments in private equity funds, real estate funds, hedge funds
and direct equity investments. Direct equity investments are presented in the fair value hierarchy table as
Principal investments and Other. Initially, the transaction price is generally considered by the Company
as the exit price and is the Company’s best estimate of fair value.
After initial recognition, in determining the fair value of internally and externally managed funds, the
Company considers the net asset value of the fund provided by the fund manager to be the best estimate
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