Morgan Stanley 2014 Annual Report Download - page 181

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
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 in 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 certain types of interest rate
derivatives with both volatility and correlation exposure and credit derivatives, including credit default
swaps on certain mortgage-backed or asset-backed securities and basket 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 credit default swaps on certain mortgage-backed or asset-backed securities, for
which observability of external price data is 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 available comparable market
levels as well as a cash synthetic basis or 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, 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.
For further information on the valuation techniques for OTC derivative products, see Note 2.
For further information on derivative instruments and hedging activities, see Note 12.
Investments.
• The Company’s investments include direct investments in equity securities as well as investments in
private equity funds, real estate funds and hedge funds, which include investments made in connection
177