Goldman Sachs 2004 Annual Report Download - page 79

GOLDMAN฀SAC H S ฀ 2004฀ A N N U A L ฀ R E P ORT ฀ ฀ ฀ 7 7
notes฀to฀consolidated฀financial฀statements
GOLDMAN฀SAC H S ฀ 2004฀ A N N U A L ฀ R E P ORT ฀ ฀ ฀ 7 7
• c ash฀tr a d i ng฀instru ments฀– ฀Fair values of the firm’s
cash trading instruments are generally obtained from
quoted market prices in active markets, broker or dealer
price quotations, or alternative pricing sources with rea-
sonable levels of price transparency. The types of instru-
ments valued in this manner include U.S. government
and agency securities, other sovereign government obli-
gations, liquid mortgage products, investment-grade
corporate bonds, listed equities, money market securities,
state, municipal and provincial obligations, and physical
commodities.
Certain cash trading instruments trade infrequently and,
therefore, have little or no price transparency. Such instru-
ments may include certain high-yield debt, corporate bank
loans, mortgage whole loans and distressed debt. The firm
values these instruments using methodologies such as the
present value of known or estimated cash flows and gener-
ally does not adjust underlying valuation assumptions unless
there is substantive evidence supporting a change in the
value of the underlying instrument or valuation assumptions
(such as similar market transactions, changes in financial
ratios and changes in the credit ratings of the underlying
companies).
Cash trading instruments owned by the firm (long positions)
are marked to bid prices and instruments sold but not yet
purchased (short positions) are marked to offer prices. If liq-
uidating a position is reasonably expected to affect its prevail-
ing market price, the valuation is adjusted generally based on
market evidence or predetermined policies. In certain circum-
stances, such as for highly illiquid positions, management’s
estimates are used to determine this adjustment.
• d e r i vativ e ฀contracts฀–฀Fair values of the firm’s deriva-
tive contracts consist of exchange-traded and over-the-coun-
ter (OTC) derivatives and reflect cash that the firm has paid
and received (for example, option premiums or cash paid or
received pursuant to credit support agreements). Fair values
of the firm’s exchange-traded derivatives are generally deter-
mined from quoted market prices. OTC derivatives are val-
ued using valuation models. The firm uses a variety of
valuation models including the present value of known or
estimated cash flows, option-pricing models and option-
adjusted spread models. The valuation models used to derive
the fair values of the firm’s OTC derivatives require inputs
including contractual terms, market prices, yield curves,
credit curves, measures of volatility, prepayment rates and
correlations of such inputs. The selection of a model to value
an OTC derivative depends upon the contractual terms of,
and specific risks inherent in, the instrument as well as the
availability of pricing information in the market. The firm
generally uses similar models to value similar instruments.
Where possible, the firm verifies the values produced by its
pricing models to market transactions. For OTC derivatives
that trade in liquid markets, such as generic forwards, swaps
and options, model selection does not involve significant
judgment because market prices are readily available. For
OTC derivatives that trade in less liquid markets, model
selection requires more judgment because such instruments
tend to be more complex and pricing information is less
available in the market. As markets continue to develop and
more pricing information becomes available, the firm
continues to review and refine the models it uses.
At the inception of an OTC derivative contract (day one),
the firm values the contract at the model value if the firm
can verify all of the significant model inputs to observable
market data and verify the model to market transactions.
When appropriate, valuations are adjusted to reflect vari-
ous factors such as liquidity, bid/offer and credit consider-
ations. These adjustments are generally based on market
evidence or predetermined policies. In certain circum-
stances, such as for highly illiquid positions, management’s
estimates are used to determine these adjustments.
Where the firm cannot verify all of the significant model
inputs to observable market data and verify the model to
market transactions, the firm values the contract at the
transaction price at inception and, consequently, records
no day one gain or loss in accordance with Emerging Issues
Task Force (EITF) Issue No. 02-3, “Issues Involved in
Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and
Risk Management Activities.”
Following day one, the firm adjusts the inputs to valuation
models only to the extent that changes in such inputs can
be verified by similar market transactions, third-party
pricing services and/or broker quotes or can be derived
from other substantive evidence such as empirical market
data. In circumstances where the firm cannot verify the
model to market transactions, it is possible that a different
valuation model could produce a materially different esti-
mate of fair value.
• p r i n c i pa l ฀ i n v e s t m e n t s ฀– ฀In valuing corporate and
real estate principal investments, the firm’s portfolio is sepa-
rated into investments in private companies, investments
BES฀•฀Phone฀(201)฀635-5240฀฀•฀FAX฀(201)฀635-5199
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