What's Fair About This Value - FX & Energy Derivative Valuations

Document Sample
What's Fair About This Value - FX & Energy Derivative Valuations Powered By Docstoc
					What’s Fair About This Value?
FX & Energy Derivative Valuations


   Michael Corley and Phil Weeber

       TEXPO – April 3-5, 2011
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of a energy derivatives

 Common valuation pitfalls




                                      2
Understanding Fair Value
 “Fair value is the price that would be received to sell an asset or paid to transfer a
  liability in an orderly transaction between market participants at the
  measurement date.” (ASC 820/FAS 157)

      Exit price (transfer price, NOT termination price): The price that would be paid to
       transfer a liability to another party with similar credit risk – the liability is assumed to
       continue (not to be settled)

      Market participants: Buyers and sellers that are independent, knowledgeable, able, and
       willing

      Transaction is a hypothetical transaction at the measurement date, considered from the
       perspective of how a market participant would value the asset or the liability, considered
       from the perspective of a market participant that holds the asset or owes the liability
Understanding Fair Value (cont.)
 Similar Credit Risk: No specific methodology is prescribed in the accounting literature for
  calculating Credit Value Adjustments (CVAs)

 Required inputs to calculate CVAs:
     Trade-level details:      Type of trade, notional, maturity, expected cash flows
     Portfolio content:        Required for netting
     Market data:              Interest rates, FX rates, volatility, correlations
     Credit spreads:           Probability of default, loss given default
     Credit enhancements: Collateral



                                 The Fair Value Continuum
  Reliable/Verifiable                                             Subjective/Less Reliable
            Level 1                         Level 2                        Level 3
        Quoted Prices in            Valuation Techniques –         Valuation Techniques –
         Active Markets                Observable Inputs            Unobservable Inputs
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of natural gas derivative

 Common valuation pitfalls




                                        5
Valuation Building Blocks
Discounting Future Cash Flows


 A bird in hand is better than a bird in two weeks…
              1
 PV =               FV
            (1+i)n

   –   PV         Present value
   –   i          Discount rate for period
   –   n          Number of periods
   –   FV         Future value

 Example: If I am owed $1,000 in 2 years, what is the
  present value (assume my personal discount rate is 5%) ?
     PV = 1 / (1 + 0.05)2 x $1,000 = $907.03

 The big question becomes  What discount rate?

                                    6
Valuation Building Blocks
Discounting Future Cash Flows




 Markets provide rates for standard contracts and for spot starting
  structures
                                  7
Valuation Building Blocks
Applying the Forward Curve


 Market data is used to construct the forward curve

 Cash flows at different points in time will be discounted at
  different discount rates

    6.0%
    5.0%
    4.0%
    3.0%
    2.0%
                                               1-month LIBOR Forward Curve
    1.0%
    0.0%
           Apr-11


                    Apr-12


                             Apr-13


                                      Apr-14


                                               Apr-15


                                                        Apr-16


                                                                 Apr-17


                                                                          Apr-18


                                                                                   Apr-19


                                                                                            Apr-20


                                                                                                     Apr-21
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of energy derivatives

 Common valuation pitfalls




                                    9
Valuation of Forward Contracts
A Foreign Exchange Contract


 A currency forward is an agreement between two counterparties to exchange
  one set amount of currency for another set amount of a different currency on
  a specific date

 Key terminology:
       Notional:            The currency amounts
       Settlement Date:     The date on which the currencies will be exchanged
       Exchange rate:       The rate that will be used to convert currencies
       Forward direction:   Which counterparty is selling which currency




                                          10
Valuation of Forward Contracts
A Foreign Exchange Contract



 Example:
    A Texas company (TEXCO) has sold two deliveries of widgets to a Mexican
     corporation (MEXCO). The deliveries will be made on September 1 and October 1.
     Payments of 10,000,000 Mexican Peso will be made by MEXCO upon receipt of
     each shipment.

    TEXCO enters into a derivative with a bank and set a flat-forward exchange rate of
     12.20 USD-MXN for Sep 1 and Oct 1 settlements
        TEXCO agrees to deliver MXN 10,000,000 on Sep 1 and Oct 1
              TEXCO would get the MXN from MEXCO at the time of delivery
        Bank counterparty agrees to deliver USD 819,672 on Sep 1 and Oct 1




                                          11
Valuation of Forward Contracts
A Foreign Exchange Contract



                           10,000,000 MXN
           MEXCO                                     TEXCO

                              Widgets

                                          $819,672           10,000,000 MXN



                                                      Bank


 Once TEXCO enters into its Forward contract, TEXCO removes its exposure
  to USD-MXN exchange rates


                                    12
Valuation of Forward Contracts
A Foreign Exchange Contract

 The currency exchange rate will change over time




     EUR-USD rates have risen                        The USD has weakened versus
      and fallen by 20% in less                        JPY for the past 5 years with
      than 6 months                                    decreases of more than 10% in
                                                       one quarter



     BRL has weakened versus
      USD by as much as 50% in
            less than 3 months


                                    13
Valuation of Forward Contracts
A Foreign Exchange Contract


 The value of TEXCO’s FX contracts will be the present value of the difference
  between the agreed upon exchange rate and the forward rate on valuation date

 For our example, let’s assume that USD-MXN rates rose. The Sep 1 forward rate is
  now 12.30 USD-MXN. The Oct 1 forward rate is now 12.34 USD-MXN.

             12.70
                                       USD-MXN on Trade Date
             12.60
             12.50                     USD-MXN on June 30
             12.40
             12.30
             12.20
             12.10
             12.00
                     Apr-11




                                                         Oct-11




                                                                                    Apr-12
                              Jun-11




                                                                  Dec-11
                                           Aug-11




                                                                           Feb-12
                                                    14
Valuation of Forward Contracts
A Foreign Exchange Contract



 Calculating the value of our derivatives:
     For the Sep 1 forward:
          If TEXCO entered into a forward today, if TEXCO delivered 10,000,000 MXN then TEXCO would
           receive $813,008
          The derivative contract will deliver $819,672 – a $6,664 premium
          Assuming a discount factor of 0.9996 – this forward has a mark-to-market value of $6,661
     For the Oct 1 forward:
          If TEXCO entered into a forward today, if TEXCO delivered 10,000,000 MXN then TEXCO would
           receive $810,373
          The derivative contract will deliver $819,672 – a $9299 premium
          Assuming a discount factor of 0.9991 – this forward has a mark-to-market value of $9291


 The two forwards have a combined mark-to-market value of $15,952



                                               15
Valuation of Forward Contracts
A Foreign Exchange Contract


 In Fair Value terminology – $15,952 is the termination price
 The termination price must be adjusted to calculate a transfer price – the
  hypothetical price that would be paid to transfer the derivatives to a
  counterparty with similar credit risk
 The inputs to make the credit value adjustment (CVA) are observable
  inputs – therefore the fair value will be Level 2
 The CVA will be a function of TEXCO’s ability to pay the bank if exchange
  rates decreased, a function of the bank’s ability to pay TEXCO, dependent
  upon whether other trades could be netted against this transaction, and
  dependent whether collateral is exchanged.
 Assume the CVA is calculated to be a $847 adjustment, the Fair Value of
  the two FX contracts would be $15,952 – $847 = $15,105



                                      16
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of energy derivatives

 Common valuation pitfalls




                                    17
Valuation of Energy Derivatives
Diesel Fuel Swaps


 A diesel fuel swap is an agreement between two counterparties to exchange
  cash flows, whereby the buyer of the swap pays a fixed price and receives a
  floating price. Diesel fuel swaps allow the buyer to “lock in” a fuel price for a
  specific date or period of time.

 Key terminology:
       Quantity:          Volume, in gallons or barrels, per month, quarter or year.
       Underlying:        The floating price index i.e. Platts Gulf Coast diesel fuel.
       Fixed Price:       The price paid by the buyer of the swap.
       Settlement Date:   The date or period of time on which the floating price is
                           calculated.




                                         18
Valuation of Energy Derivatives
Diesel Fuel Swaps


 Example:

    You are a mining company that consumes large volumes of diesel fuel. As such
     you have signed a contract with your fuel supplier for them to deliver 250,000
     gallons of fuel to your facility during May and June. The contract calls states that
     you will pay the Platts’ Gulf Coast diesel fuel spot price.

    In order to ensure that your meet your budget you determine that you need to
     hedge your exposure to potentially rising diesel fuel prices.

    On Apr 4 you ask your bank to quote you a swap on the May – June Platts’ Gulf
     Coast diesel fuel for 250,000 gallons per month.




                                          19
Valuation of Energy Derivatives
Diesel Fuel Swaps


 The current May and June Gulf Coast diesel fuel forwards are:
     May - $3.00
     Jun - $3.25
 The relevant risk free rates are:
     May - 3.0%
     Jun - 3.5%
 The corresponding discount rates are:
     May - .9978
     Jun - .9945
 All of which equate to a PV of $3.1248
 Thus your bank will you sell you the swap at $3.1273/gallon (PV + their profit
  margin of $.0025)



                                       20
Valuation of Energy Derivatives
Diesel Fuel Swaps




                         $3.1273


       Mining Co.                            Bank


                      Platts’ Gulf Coast
                    Diesel Fuel Spot Price




                                21
Valuation of Energy Derivatives
Diesel Fuel Swaps


 Calculating the value of our fuel derivatives on Apr 30
     For the May swap
          On Apr 30 the value of the May forward has increased to $3.30
          Assuming a discount factor of 0.9999 – the May swap has a value of $3.2997
     For the June swap
          On Apr 30 the value of the June forward has increased to $3.50
          Assuming a discount factor of 0.9970 – the June swap has a value of $3.4895


 The two fuel swaps have a combined mark-to-market value of $133,648




                                            22
Valuation of Energy Derivatives
Diesel Fuel Swaps


  In Fair Value terminology – $133,648 is the termination price
  The termination price must be adjusted to calculate a transfer price – the
   hypothetical price that would be paid to transfer the derivatives to a
   counterparty with similar credit risk
  The inputs to make the credit value adjustment (CVA) are observable
   inputs – therefore the fair value will be Level 2
  The CVA will be a function of the mining company’s ability to pay the bank
   if diesel prices dropped, a function of the bank’s ability to pay, dependent
   upon whether other trades could be netted against this transaction, and
   dependent whether collateral is exchanged.
  Assume the CVA is calculated to be a $9,645 adjustment, the Fair Value of
   the two FX contracts would be $133,648 - $9,645 = $124,003



                                      23
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of energy derivatives

 Common valuation pitfalls




                                    24
Valuation Pitfalls

 Value that your bank sent you                FAS 157 value


 Basis adjustment
    You can’t use a forward curve constructed from 3-month LIBOR to value an
     instrument with monthly cash flows
    You can’t use a forward curve constructed from NYMEX Heating Oil futures to
     value your delivery of diesel in Dallas


 The details matter
      Day count conventions
      Length of payment periods
      Roll dates
      Country-specific holidays



                                      25
Questions?



     Q&A from participants

     Final thoughts




                              26
Contact Information

Michael Corley                      Phil Weeber
President                           Director, Hedge Advisory
T: 713.844.6384                     T: 484.731.0241




Mercatus Energy Advisors            Chatham Financial
3333 Richmond Ave, Suite 300        235 Whitehorse Lane
Houston, TX 77098                   Kennett Square, PA 19348
Main: 713.970.1003                  Main: 610.925.3120
Fax: 713.481.8387                   Fax: 610.925.3125
www.MercatusEnergy.com              www.ChathamFinancial.com




                               27

				
DOCUMENT INFO
Shared By:
Stats:
views:57
posted:4/11/2011
language:English
pages:27
Description: 2011 TEXPO Presentation: What's Fair About This Value - FX & Energy Derivative Valuations
Mercatus Energy Advisors Mercatus Energy Advisors Energy Hedging & Risk Management Consultants http://www.mercatusenergy.com
About Mercatus Energy Advisors is the leading, independent energy hedging and risk management advisory firm.