Valuation and transparency – Facing the challenges of risk and transparency

How are the rapidly changing needs of clients, regulators and the financial industry generally being met by software vendors?

Robert Park (RP): Significant global market changes now require financial institutions to re-examine approaches to measuring and mitigating risks. With market volatility, counterparty risk and regulatory pressures, the market needs transparency and independent valuations. With today’s increasing demand for transparency and accountability, the financial industry requires extremely flexible solutions.

To better meet the market’s need to value more complex structured products and the need for better risk measurement, solutions need to be highly flexible and provide detailed, comprehensive risk reports. In addition, solutions should also provide complete transparency with extensive documentation and traceability, and show internal and external stakeholders how the structure was valued.

How have traditional risk management techniques fared through the recent turmoil?

RP: Overall, value-at-risk (VaR) has proved to be a poor indicator of performance in times of market stress. However, the traditional market risk analysis employed in all business areas outside of credit has continued to prove useful. While market risk is still being managed effectively, credit and liquidity risks were a problem and remain problematic. Having more transparent disclosures of processes and methods behind taking positions may help in foreseeing or mitigating some of those risks. 

Can transparency in structured portfolios be realistically achieved and, if so, how?

RP: One of the key challenges in this market is the inherent difficulty in valuing these complex instruments and providing the transparency that is increasingly being required by both internal stakeholders and investors. Firms can help improve transparency by using more than one tool to provide an independent valuation to verify the value. Not only do these solutions need to provide the methodology behind the models used to generate the numbers, but they also need to go one step further and provide traceability. Whether it is audit logs to recreate how the structure was valued or comprehensive cashflow reports, this kind of additional information is a necessary step to improve upon the transparency of these complex structures.

Who is driving the demand for valuation analyses and transparency – regulators and central banks, or the investors themselves?

RP: All parties involved are looking for better analysis and increased transparency. The recent turmoil had a significant impact on the industry and growth is slowly returning. Regulators have taken a strong position in most regions in an attempt to prevent another crisis, and investors themselves are going to be more cautious going forward. Investors are demanding more transparency, so firms require a system or solution that will enable them to provide this information to their investors. To maintain investor confidence and meet regulatory requirements, firms need to show the models and methodology used in their valuations and how this was implemented. This kind of transparency is now essential to rebuilding the confidence that was lost.

What is so important about scenario-based risk management?

RP: Scenario-based risk management is extremely important because it gives organisations a comprehensive view of their risk. The lesson learned was that organisations need to move beyond looking only at the known financial risk, but to look at all risk. Organisations, regulators and stakeholders are requiring more than VaR and capital adequacy. While this information is obviously very important in evaluating risk, there needs to be additional focus on scenario analysis and stress testing. Firms need to improve the management of risk and this means that the current data management, cashflow generation and scenario-simulation techniques will be stretched to the limit. Highly flexible, grid-enabled, computationally efficient scenario-analysis and stress-testing tools will be needed to supplement existing technologies.

What does the future hold for the risk and valuation processes used in the structured products industry?

RP: The inability of models to capture all risk is a shortcoming, particularly during periods of extreme market volatility as we have seen in the crisis. Robust, transparent and standardised models that provide risk measures for all model inputs at all times are needed to improve the stress-testing capabilities of banks and the modelling of extreme events. In addition, a greater emphasis on independent valuation and transparency will also be crucial if financial institutions are to meet the challenges posed by rapidly changing market conditions and greater regulatory scrutiny.

In order to help those valuing structured products and meet the challenges they will face in the coming years, FINCAD has launched F3 SDK and F3 Excel Edition. The F3 product line will provide improved support for structured products with greater flexibility and comprehensive, detailed risk reporting that supports grid computing for faster performance and valuation. F3 also provides the transparency the industry requires with complete maths documentation and traceability through audit logs and complete cashflow reports.