Goldman Sachs 2007 Annual Report Download - page 95

Notes to Consolidated Financial Statements
For positions that are not traded in active markets or are
subject to transfer restrictions, valuations are adjusted to reflect
illiquidity and/or non-transferability, and such adjustments
are generally based on available market evidence. In the
absence of such evidence, management’s best estimate is used.
■ DERIVATIVE CONTRACTS. Derivative contracts can be
exchange-traded or over-the-counter (OTC). Exchange-traded
derivatives typically fall within level 1 or level 2 of the fair
value hierarchy depending on whether they are deemed to be
actively traded or not. The firm generally values 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. In such
cases, exchange-traded derivatives are classified within level 2
of the fair value hierarchy.
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. The firm
generally uses 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. Such instruments are
typically classified within level 2 of the fair value hierarchy.
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. Such
instruments are classified within level 3 of the fair value
hierarchy. Where the firm does 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. The valuations of these less liquid OTC
derivatives are typically based on level 1 and/or level 2 inputs
that can be observed in the market, as well as unobservable
level 3 inputs. Subsequent to initial recognition, the firm
updates the level 1 and level 2 inputs to reflect observable
market changes, with resulting gains and losses reflected
within level 3. Level 3 inputs are only changed when
corroborated by evidence such as similar market transactions,
A financial instrument’s level within the fair value hierarchy
is based on the lowest level of any input that is significant
to the fair value measurement. See “ — Recent Accounting
Developments” for a discussion of the impact of adopting
SFAS No. 157.
In determining fair value, the firm separates its “Financial
instruments owned, at fair value” and its “Financial instruments
sold, but not yet purchased, at fair value” into two categories:
cash instruments and derivative contracts.
■ CASH INSTRUMENTS.
The firm’s cash instruments are generally
classified within level 1 or level 2 of the fair value hierarchy
because they are valued using quoted market prices, broker
or dealer quotations, or alternative pricing sources with
reasonable levels of price transparency. The types of
instruments valued based on quoted market prices in active
markets include most U.S. government and agency securities,
many other sovereign government obligations, active listed
equities and most money market securities. Such instruments
are generally classified within level 1 of the fair value hierarchy.
The firm does not adjust the quoted price for such instruments,
even in situations where the firm holds a large position and a
sale could reasonably impact the quoted price.
The types of instruments valued based on quoted prices in
markets that are not active, broker or dealer quotations, or
alternative pricing sources with reasonable levels of price
transparency include most investment-grade and high-yield
corporate bonds, most mortgage products, certain corporate
bank and bridge loans, less liquid listed equities, state,
municipal and provincial obligations, most physical
commodities and certain loan commitments. Such instruments
are generally classified within level 2 of the fair value hierarchy.
Certain cash instruments are classified within level 3 of the fair
value hierarchy because they trade infrequently and therefore
have little or no price transparency. Such instruments include
private equity and real estate fund investments, certain
corporate bank and bridge loans, less liquid mortgage whole
loans, distressed debt instruments and certain loan commitments.
The 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. This valuation
is adjusted only when changes to inputs and assumptions are
corroborated by evidence such as 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.
93Goldman Sachs 2007 Annual Report