Morgan Stanley 2014 Annual Report Download - page 166

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
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, model uncertainty and concentration risk. 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 (primarily 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 value for short-term and long-term borrowings. For OTC derivatives, the impact of changes in
both the Company’s and the counterparty’s credit rating is considered when measuring fair value. In determining
the expected exposure, the Company simulates the distribution of the future exposure to a counterparty, then
applies market-based default probabilities to the future exposure, leveraging external third-party credit default
swap (“CDS”) spread data. Where CDS spread data are unavailable for a specific counterparty, bond market
spreads, CDS spread data based on the counterparty’s credit rating or CDS spread data that reference a
comparable counterparty may be utilized. The Company also considers collateral held and legally enforceable
master netting agreements that mitigate the Company’s exposure to each counterparty. Adjustments for model
uncertainty are taken for positions whose underlying models are reliant on significant inputs that are neither
directly nor indirectly observable, hence requiring reliance on established theoretical concepts in their derivation.
These adjustments are derived by making assessments of the possible degree of variability using statistical
approaches and market-based information where possible. The Company generally subjects all valuations and
models to a review process initially and on a periodic basis thereafter. The Company may apply a concentration
adjustment to certain of its OTC derivatives portfolios to reflect the additional cost of closing out a particularly
large risk exposure. Where possible, these adjustments are based on observable market information, but in many
instances, significant judgment is required to estimate the costs of closing out concentrated risk exposures due to
the lack of liquidity in the marketplace.
During the fourth quarter of 2014, the Company incorporated funding valuation adjustments (“FVA”) into the
fair value measurements of OTC uncollateralized or partially collateralized derivatives, and in collateralized
derivatives where the terms of the agreement do not permit the reuse of the collateral received. The Company’s
implementation of FVA reflects the inclusion of FVA in the pricing and valuations by the majority of market
participants involved in the Company’s principal exit market for these instruments. In general, FVA reflects a
market funding risk premium inherent in the noted derivative instruments. The methodology for measuring FVA
leverages the Company’s existing credit-related valuation adjustment calculation methodologies, which apply to
both assets and liabilities.
Fair value is a market-based measure considered from the perspective of a market participant rather than an
entity-specific measure. Therefore, even when market assumptions are not readily available, the Company’s own
assumptions are set to reflect those that the Company believes market participants would use in pricing the asset
or liability at the measurement date. Where the Company manages a group of financial assets and financial
liabilities on the basis of its net exposure to either market risks or credit risk, the Company measures the fair
value of that group of financial instruments consistently with how market participants would price the net risk
exposure at the measurement date.
See Note 4 for a description of valuation techniques applied to the major categories of financial instruments
measured at fair value.
162