Whatâ€™s Fair About This Value?

What’s Fair About This Value?

FX & Energy Derivative Valuations

Michael Corley and Phil Weeber

TEXPO – April 3-5, 2011

http://www.mercatusenergy.com/

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What is a Fair Value?

Valuation building blocks

Valuation of a currency forward

Valuation of a energy derivatives

Common valuation pitfalls

Session Overview


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 ContinuumReliable/Verifiable Subjective/Less Reliable

Level 1 Level 2 Level 3

Quoted Prices in Valuation Techniques – Valuation Techniques –

Active Markets Observable Inputs Unobservable Inputs


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Session Overview




Valuation of natural gas derivative



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Valuation Building BlocksDiscounting Future Cash Flows

A bird in hand is better than a bird in two weeks…

PV = FV

– 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?

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(1+i)n


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Valuation Building BlocksDiscounting Future Cash Flows

Markets provide rates for standard contracts and for spot starting structures


Applying the Forward CurveValuation Building Blocks

Market data is used to construct the forward curve

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

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1-month LIBOR Forward Curve


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Valuation of energy derivatives


Session Overview


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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

Valuation of Forward ContractsA Foreign Exchange Contract


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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



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TEXCOMEXCO

10,000,000 MXN

Widgets

Bank

$819,672 10,000,000 MXN

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


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Valuation of Forward Contracts

The currency exchange rate will change over time

A Foreign Exchange Contract

EUR-USD rates have risen and fallen by 20% in less than 6 months

The USD has weakened versus JPY for the past 5 years with decreases of more than 10% in one quarter

BRL has weakened versus USD by as much as 50% in

less than 3 months


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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.


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USD-MXN on June 30


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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



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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



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Session Overview


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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.

Valuation of Energy DerivativesDiesel Fuel Swaps


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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.



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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)



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BankMining Co.

$3.1273

Platts’ Gulf Coast Diesel Fuel Spot Price


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Valuation of Energy Derivatives

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

Diesel Fuel Swaps


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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


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Session Overview


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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


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Questions?

Q&A from participants

Final thoughts


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Contact Information

Mercatus Energy Advisors3333 Richmond Ave, Suite 300Houston, TX 77098Main: 713.970.1003Fax: 713.481.8387www.MercatusEnergy.com

Chatham Financial 235 Whitehorse LaneKennett Square, PA 19348Main: 610.925.3120Fax: 610.925.3125 www.ChathamFinancial.com

Phil Weeber

Director, Hedge Advisory

T: 484.731.0241

Michael Corley

President

T: 713.844.6384


http://www.chathamfinancial.com/

http://www.chathamfinancial.com/

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Whatâ€™s Fair About This Value?