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Over-the-counter derivatives will exceed the USD550trn mark in 2008, up from USD375trn at the end of 2006, according to a new report from Celent, a research and consulting firm that focuses on the application of information technology in the global financial services industry.
Growing OTC derivatives trading volume, escalating exposure to OTC derivatives and structured deals, the increased complexity of products and lack of trade automation have increased the importance of accurate valuation, according to the report, entitled Risk and Pricing Analytics: Addressing Valuation Challenges in OTC and Structured Products.
Recent losses suffered by Amaranth Advisors and Bank of Montreal illustrate the risks associated with the use of derivative instruments, according to Celent, and bring to light the need to address inappropriate valuation practices and insufficient management oversight.
The report says pricing and valuation of financial assets are core to a financial institution's existence and tied to the stability of the financial sector as a whole, and therefore getting it right is crucial.
'As a whole, the determination of fair market value for the positions that make up a complex trade, fund, or portfolio is, more often than not, fraught with complications,' says Celent analyst Cubillas Ding, the author of the report. 'Complexities often arise from multi-layered product valuation requirements, the fault-prone use of spreadsheets, and the transparency of valuation processes.'
To address this situation, he says, vendors have adopted different 'routes to market' for pricing analytics. Solutions are differentiated along several lines: specialised versus mixed asset models, coverage across various parts of the OTC and structuring lifestyle, scope of vendors' analytics, and the quality of partnerships related to market data, integrated trading, and risk management systems.
Ding says that institutions implementing pricing solutions need to weigh the level of granularity required for their OTC derivatives and structured products valuation activities, the type and nature of users, and time-to-market considerations in the context of the availability of internal resources. 'Each approach trades off granularity, end-user focus, and time to market,' he says.
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