Pricing of Illiquid Instruments and Transactions

Illiquid, non-traditional, and user-specific or customized transactions pose particular pricing challenges because independent third-party prices are generally unavailable. For illiquid products that are traded on organized exchanges, but for which trades occur infrequently and available quotes are often not current, mark-to-market valuations based on the illiquid market quotes may be adjusted by a holdback reserve that is created to reflect the product’s reduced liquidity. (See ‘‘Holdback Reserves’’ below.) For illiquid OTC transactions, broker quotes may be available, albeit infrequently. When broker quotes are available, the bank may use several quotes to determine a final representative valuation. For example, the bank may compute a simple average of quotes or eliminate extreme prices and average the remaining quotes. In such cases, internal policies should clearly identify the methodology to be used.

When the middle or back office is responsible for inputting broker quotes directly, the traders should also be responsible for reporting their positions to the middle- or back-office function as an added control. Any differences in pricing should be reconciled. When brokers are responsible for inputting data directly, it is crucial that the middle or back office verify these data for accuracy and appropriateness.

For many illiquid or customized transactions, such as highly structured or leveraged instruments and more complex, nonstandard notes or securities, reliable independent market quotes are usually not available, even infrequently. In such instances, other valuation techniques must be used to determine a theoretical, end-of-day market value. These techniques may involve assuming a constant spread over a reference rate or comparing the transaction in question with similar transactions that have readily available prices (for example, comparable or similar transactions with different counterparties). More likely, though, pricing models will be used to price these types of customized transactions. Even when exchange prices exist for a financial instrument, there may be market anomalies in the pricing; these anomalies make consistent pricing across the instrument difficult. For example, timing differences may exist between the close of the cash market and futures markets, causing a divergence in pricing. In these cases, it may be appropriate to use theoretical pricing, and pricing models may again be used for this purpose.

When conducting the monthly revaluation, the validity of portfolio prices can be tested by reviewing them for historical consistency or by comparing actual close-out prices or the performance of hedge positions to model predictions. In some instances, controllers may run parallel pricing models as a check on the valuations derived by trader models. This method is usually only used for the more exotic, harder-to-price products.