Morgan Stanley 2015 Annual Report Download - page 151

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Asset/Liability Valuation Technique Valuation Hierarchy Classification
OTC Derivative Contracts
OTC derivative contracts include forward, swap and option
contracts related to interest rates, foreign currencies, credit
standing of reference entities, equity prices or commodity
prices.
Depending on the product and the terms of the transaction, the
fair value of OTC derivative products can be either observed
or modeled using a series of techniques and model inputs from
comparable benchmarks, including closed-form analytic
formulas, such as the Black-Scholes option-pricing model, and
simulation models or a combination thereof. Many pricing
models do not entail material subjectivity because the
methodologies employed do not necessitate significant
judgment, and the pricing inputs are observed from actively
quoted markets, as is the case for generic interest rate swaps,
certain option contracts and certain CDS. In the case of more
established derivative products, the pricing models used by the
Company are widely accepted by the financial services
industry.
Other derivative products, including complex products that
have become illiquid, require more judgment in the
implementation of the valuation technique applied due to the
complexity of the valuation assumptions and the reduced
observability of inputs. This includes certain types of interest
rate derivatives with both volatility and correlation exposure
and credit derivatives, including CDS on certain mortgage-
backed or asset-backed securities and basket CDS, where
direct trading activity or quotes are unobservable.
Derivative interests in CDS on certain mortgage-backed or
asset-backed securities, for which observability of external
price data is limited, are valued based on an evaluation of the
market and model input parameters sourced from similar
positions as indicated by primary and secondary market
activity. Each position is evaluated independently taking into
consideration available comparable market levels as well as a
cash synthetic basis or the underlying collateral performance
and pricing, behavior of the tranche under various cumulative
loss and prepayment scenarios, deal structures (e.g., non-
amortizing reference obligations, call features, etc.) and
liquidity. While these factors may be supported by historical
and actual external observations, the determination of their
value as it relates to specific positions nevertheless requires
significant judgment.
For basket CDS, the correlation input between reference
credits is unobservable for each specific swap or position and
is benchmarked to standardized proxy baskets for which
correlation data are available. The other model inputs such as
credit spread, interest rates and recovery rates are observable.
The Company trades various derivative structures with
commodity underlyings. Depending on the type of structure,
• Generally Level 2 - OTC derivative
products valued using pricing models;
basket CDS if the correlation input is not
deemed to be significant; commodity
derivatives
• Level 3 - OTC derivative products with
significant unobservable inputs; basket
CDS if the correlation input is deemed to
be significant; commodity derivatives in
instances where significant inputs are
unobservable
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