Morgan Stanley 2015 Annual Report Download - page 137

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the
degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3 of
the fair value hierarchy.
The Company considers prices and inputs that are current as of the measurement date, including during periods of market
dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments.
This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3 of the fair value
hierarchy (see Note 3).
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases,
for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement falls in its entirety is
determined based on the lowest level input that is significant to the fair value measurement in its entirety.
For assets and liabilities that are transferred between Levels in the fair value hierarchy during the period, fair values are
ascribed as if the assets or liabilities had been transferred as of the beginning of the period.
Valuation Techniques.
Many cash instruments and OTC derivative contracts have bid and ask prices that can be observed in the marketplace. Bid
prices reflect the highest price that a party is willing to pay for an asset. Ask prices represent the lowest price that a party is
willing to accept for an asset. The Company carries positions at the point within the bid-ask range that meet its best estimate
of fair value. For offsetting positions in the same financial instrument, the same price within the bid-ask spread is used to
measure both the long and short positions.
Fair value for many cash instruments and OTC derivative contracts is derived using pricing models. Pricing models take into
account the contract terms as well as multiple inputs, including, where applicable, commodity prices, equity prices, interest
rate yield curves, credit curves, correlation, creditworthiness of the counterparty, creditworthiness of the Company, option
volatility and currency rates.
Where appropriate, valuation adjustments are made to account for various factors such as liquidity risk (bid-ask adjustments),
credit quality, model uncertainty and concentration risk. Adjustments for liquidity risk adjust model-derived mid-market
levels of Level 2 and Level 3 financial instruments for the bid-mid or mid-ask spread required to properly reflect the exit
price of a risk position. Bid-mid and mid-ask spreads are marked to levels observed in trade activity, broker quotes or other
external third-party data. Where these spreads are unobservable for the particular position in question, spreads are derived
from observable levels of similar positions.
The Company applies credit-related valuation adjustments to its short-term and long-term borrowings (primarily structured
notes) for which the fair value option was elected and to OTC derivatives. The Company considers the impact of changes in
its own credit spreads based upon observations of the secondary bond market spreads when measuring the fair value for
short-term and long-term borrowings. For OTC derivatives, the impact of changes in both the Company’s and the
counterparty’s credit rating is considered when measuring fair value. In determining the expected exposure, the Company
simulates the distribution of the future exposure to a counterparty, then applies market-based default probabilities to the
future exposure, leveraging external third-party credit default swap (“CDS”) spread data. Where CDS spread data are
unavailable for a specific counterparty, bond market spreads, CDS spread data based on the counterparty’s credit rating or
CDS spread data that reference a comparable counterparty may be utilized. The Company also considers collateral held and
legally enforceable master netting agreements that mitigate its exposure to each counterparty.
Adjustments for model uncertainty are taken for positions whose underlying models are reliant on significant inputs that are
neither directly nor indirectly observable, hence requiring reliance on established theoretical concepts in their derivation.
These adjustments are derived by making assessments of the possible degree of variability using statistical approaches and
market-based information where possible. The Company generally subjects all valuations and models to a review process
initially and on a periodic basis thereafter.
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