Valuation Risk - Managing Valuation Risk

Managing Valuation Risk

Valuation risks result from data management issues such as: Accuracy, integrity and consistency of static data. Accuracy and timeliness of information such as corporate events, credit events, or news potentially impact them. Streaming data, such as prices, rates, volatilities are even more vulnerable as they also depend on IT infrastructure and tools therefore adding a notion of technical and connectivity risk.

Some financial institutions have setup centralised data management platforms, open to multiple sources of static and streaming data where all financial instruments traded or held can possibly be defined, documented, priced, historised and distributed across the enterprise. Such centralisation facilitates data cleansing, historising and auditing allow organisations to define and control pricing and valuation procedures as required for compliance. For OTC instruments, the platforms also involve the definition and storage of underlying information such as yield curves and credit curves, volatility surfaces, ratings and correlation matrices and probabilities of default.

In addition, an important aspect of managing valuation risk is associated with model risk. In search of transparency, market participants tend to adopt multiple model approaches and rely on consensus rather than science. In the absence of deep and liquid market transactions, and given the highly non-linear nature of some of the structured products, the mark-to-model process itself requires transparency. To achieve this, open pricing platforms may be linked to the centralised data warehouse. Those platforms are capable of using multiple models, scenarios, data sets with various distribution and dispersion models to price and re-price under ever changing assumptions.

The final aspect of managing valuation risks relate to the actions that can be taken within the firm as a result of the assessments of exposures and sensitivities reported. The management of tail risks should also be reviewed so that allocating economic capital weighted by a very low probability of occurrence of an event amounted to considering a normal distribution of events or simply overlooking the tail risk.