Goldman Sachs 2007 Annual Report Download - page 48

Management’s Discussion and Analysis
Certain OTC derivatives trade in less liquid markets with limited
pricing information, and the determination of fair value for
these derivatives is inherently more difficult. Where we do not
have corroborating market evidence to support significant
model inputs and cannot verify the model to market transactions,
transaction price is initially used as the best estimate of fair
value. Accordingly, when a pricing model is used to value such
an instrument, the model is adjusted so that the model value
at inception equals the transaction price. Subsequent to initial
recognition, we only update valuation inputs when corroborated
by evidence such as similar market transactions, third-party
pricing services and/or broker or dealer quotations, or other
empirical market data. In circumstances where we cannot
verify the model value to market transactions, it is possible that
a different valuation model could produce a materially different
estimate of fair value. See “ — Credit Risk — Derivatives” below
for further information on our OTC derivatives.
When appropriate, valuations are adjusted for various factors
such as liquidity, bid/offer spreads and credit considerations.
Such adjustments are generally based on available market
evidence. In the absence of such evidence, management’s best
estimate is used.
FAIR VALUE HIERARCHY— LEVEL 3 ASSETS. SFAS No. 157
establishes a fair value hierarchy that prioritizes the inputs to
valuation techniques used to measure fair value. The objective
of a fair value measurement is to determine the price that
would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the
measurement date (an exit price). The hierarchy gives the highest
priority to unadjusted quoted prices in active markets for
identical assets or liabilities (level 1 measurements) and the
lowest priority to unobservable inputs (level 3 measurements).
Assets and liabilities are classified in their entirety based on the
lowest level of input that is significant to the fair value
measurement. See Notes 2 and 3 to the consolidated financial
statements for further information regarding SFAS No. 157.
■ PRIVATE PRINCIPAL INVESTMENTS. Our private principal
investments held within the Principal Investments component
of our Trading and Principal Investments segment include
investments in private equity, debt and real estate, primarily
held through investment funds. By their nature, these
investments have little or no price transparency. We value
such instruments initially at transaction price and adjust
valuations when evidence is available to support such
adjustments. Such evidence includes transactions in similar
instruments, completed or pending third-party transactions
in the underlying investment or comparable entities,
subsequent rounds of financing, recapitalizations and other
transactions across the capital structure, offerings in the
equity or debt capital markets, and changes in financial ratios
or cash flows.
DERIVATIVE CONTRACTS. Derivative contracts can be exchange-
traded or over-the-counter (OTC). We generally value exchange-
traded derivatives within portfolios using models which calibrate
to market clearing levels and eliminate timing differences
between the closing price of the exchange-traded derivatives
and their underlying cash instruments.
OTC derivatives are valued using market transactions and
other market evidence whenever possible, including market-
based inputs to models, model calibration to market clearing
transactions, broker or dealer quotations or alternative pricing
sources with reasonable levels of price transparency. Where
models are used, the selection of a particular 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. We generally use similar
models to value similar instruments. Valuation models require
a variety of inputs, including contractual terms, market prices,
yield curves, credit curves, measures of volatility, prepayment
rates and correlations of such inputs. For OTC derivatives that
trade in liquid markets, such as generic forwards, swaps and
options, model inputs can generally be verified and model
selection does not involve significant management judgment.
46 Goldman Sachs 2007 Annual Report