Goldman Sachs 2009 Annual Report Download - page 96

Goldman Sachs 2009 Annual Report
94
Notes to Consolidated Financial Statements
(level1 measurements) and the lowest priority to unobservable
inputs (level3 measurements). The three levels of the fair
value hierarchy are described below:
Basis of Fair Value Measurement
Level1 Unadjusted quoted prices in active markets that are
accessible at the measurement date for identical,
unrestricted assets or liabilities;
Level2 Quoted prices in markets that are not considered
to be active or  nancial instruments for which all
signi cant inputs are observable, either directly
orindirectly;
Level3 Prices or valuations that require inputs that are
both signi cant to the fair value measurement
and unobservable.
A  nancial instrument’s level within the fair value hierarchy is
based on the lowest level of any input that is signi cant to the
fair value measurement.
The  rm de nes active markets for equity instruments based
on the average daily trading volume both in absolute terms
and relative to the market capitalization for the instrument.
The  rm de nes active markets for debt instruments based on
both the average daily trading volume and the number of days
with trading activity.
Credit risk is an essential component of fair value. Cash
products (e.g.,bonds and loans) and derivative instruments
(particularly those with signi cant future projected cash
 ows) trade in the market at levels which re ect credit
considerations. The  rm calculates the fair value of derivative
assets by discounting future cash  ows at a rate which
incorporates counterparty credit spreads and the fair value
of derivative liabilities by discounting future cash  ows at
a rate which incorporates the  rm’s own credit spreads. In
doing so, credit exposures are adjusted to re ect mitigants,
namely collateral agreements which reduce exposures based
on triggers and contractual posting requirements. The  rm
manages its exposure to credit risk as it does other market
risks and will price, economically hedge, facilitate and
intermediate trades which involve credit risk. The  rm records
liquidity valuation adjustments to re ect the cost of exiting
concentrated risk positions, including exposure to the  rm’s
own credit spreads.
In determining fair value, the  rm separates trading assets,
at fair value and trading liabilities, at fair value into two
categories: cash instruments and derivative contracts.
▪
Cash Instruments. The  rm’s cash instruments are generally
classi ed 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 government obligations, active
listed equities and certain money market securities. Such
instruments are generally classi ed within level1 of the
fair value hierarchy. Instruments classi ed within level1 of
the fair value hierarchy are required to be carried at quoted
market prices, even in situations where the  rm holds a large
position and a sale could reasonably impact the quoted price.
The types of instruments that trade in markets that are not
considered to be active, but are valued based on quoted
market prices, broker or dealer quotations, or alternative
pricing sources with reasonable levels of price transparency
include most government agency securities, most corporate
bonds, certain mortgage products, certain bank loans
and bridge loans, less liquid listed equities, certainstate,
municipal and provincial obligations and certain
money market securities and loan commitments. Such
instruments are generally classi ed within level2 of
the fair valuehierarchy.
Certain cash instruments are classi ed 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 investments and real estate
fund investments, certain bank loans and bridge loans
(including certain mezzanine  nancing, leveraged
loans arising from capital market transactions and other
corporate bank debt), less liquid corporate debt securities
and other debt obligations (including less liquid corporate
bonds, distressed debt instruments and collateralized debt
obligations (CDOs) backed by corporate obligations), less
liquid mortgage whole loans and securities (backed by
either commercial or residential real estate), and acquired
portfolios of distressed loans. 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