Morgan Stanley 2014 Annual Report Download - page 198

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
•Comparable bond price—a pricing input used when prices for the identical instrument are not available.
Significant subjectivity may be involved when fair value is determined using pricing data available for
comparable instruments. Valuation using comparable instruments can be done by calculating an implied
yield (or spread over a liquid benchmark) from the price of a comparable bond, then adjusting that yield
(or spread) to derive a value for the bond. The adjustment to yield (or spread) should account for relevant
differences in the bonds such as maturity or credit quality. Alternatively, a price-to-price basis can be
assumed between the comparable instrument and bond being valued in order to establish the value of the
bond. Additionally, as the probability of default increases for a given bond (i.e., as the bond becomes
more distressed), the valuation of that bond will increasingly reflect its expected recovery level assuming
default. The decision to use price-to-price or yield/spread comparisons largely reflects trading market
convention for the financial instruments in question. Price-to-price comparisons are primarily employed
for RMBS, CMBS, ABS, CDOs, CLOs, Other debt, interest rate contracts, foreign exchange contracts,
Other secured financings and distressed corporate bonds. Implied yield (or spread over a liquid
benchmark) is utilized predominately for non-distressed corporate bonds, loans and credit contracts.
•Comparable equity price—a price derived from equity raises, share buybacks and external bid levels,
etc. A discount or premium may be included in the fair value estimate.
•Correlation—a pricing input where the payoff is driven by more than one underlying risk. Correlation is a
measure of the relationship between the movements of two variables (i.e., how the change in one variable
influences a change in the other variable). Credit correlation, for example, is the factor that describes the
relationship between the probability of individual entities to default on obligations and the joint
probability of multiple entities to default on obligations.
•Credit spread—the difference in yield between different securities due to differences in credit quality.
The credit spread reflects the additional net yield an investor can earn from a security with more credit
risk relative to one with less credit risk. The credit spread of a particular security is often quoted in
relation to the yield on a credit risk-free benchmark security or reference rate, typically either U.S.
Treasury or London Interbank Offered Rate (“LIBOR”).
•EBITDA multiple/Exit multiple—the ratio of the Enterprise Value to EBITDA, where the Enterprise
Value is the aggregate value of equity and debt minus cash and cash equivalents. The EBITDA multiple
reflects the value of the company in terms of its full-year EBITDA, whereas the exit multiple reflects the
value of the company in terms of its full-year expected EBITDA at exit. Either multiple allows
comparison between companies from an operational perspective as the effect of capital structure, taxation
and depreciation/amortization is excluded.
•Equity alpha—a parameter used in the modeling of equity hybrid prices.
•Funding spread—the difference between the general collateral rate (which refers to the rate applicable to
a broad class of U.S. Treasury issuances) and the specific collateral rate (which refers to the rate
applicable to a specific type of security pledged as collateral, such as a municipal bond). Repurchase
agreements and certain other secured financings are discounted based on collateral curves. The curves are
constructed as spreads over the corresponding overnight indexed swap (“OIS”) or LIBOR curves, with
the short end of the curve representing spreads over the corresponding OIS curves and the long end of the
curve representing spreads over LIBOR.
•Implied weighted average cost of capital (“WACC”)—the WACC implied by the current value of equity
in a discounted cash flow model. The model assumes that the cash flow assumptions, including
projections, are fully reflected in the current equity value, while the debt to equity ratio is held constant.
The WACC theoretically represents the required rate of return to debt and equity investors.
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