The sole driver of the valuation should be a genuine desire to find the true value of the asset. Even somebody who wants to swindle their trade partners by claiming a false value of an asset should be interested in knowing its true value as to know the expediency of their activity. At least for themselves, it is within the self-interest of any asset holder – even an outwardly dishonest one - to evaluate the assets they are holding, willing to buy or sell as precisely as possible. Obviously, a vast majority of people in the market are honest, but as Akerlof’s market for lemons suggests, even (and especially) the honest sellers are hurt by a sheer possibility of bad apples.
For many practical reasons, such as moral hazard of individuals, asymmetric information between buyers and sellers, and companies cooking the books in order to escape or artificially satisfy regulatory requirements, it is not quite obvious that financial institutions, particularly if parties to a trade, would not end up “deluding” each other. Worse yet, as this delusion needs not to be intentional, institutions may end up having deluded themselves with purpose-built, biased or straight up false valuation. This may have far reaching consequences, particularly if a host of small self-delusions accumulate to form a large one that will then suffer a painful encounter with reality.
In order to avoid mistakes, whether by omission or commission, the regulators demand that the financial assets should be valued independently, that is by a party that does not have any interest in the transaction or its aftermath. It is not always prohibited for the companies to do the valuation of their own assets but it is seldom recommended. The department performing the valuation must be completely separate, both information-wise and incentive-wise, from the activity around the valued asset, making this arrangement rather demanding with regards to governance structure.
Nevertheless, the separation is not the end to all problems. Although it has been previously stated that knowing the value of assets is paramount to navigating a financial landscape with any degree of adroitness, it was never said that such knowledge is easily acquired. In explaining that something is not difficult, we often employ the phrase “it is not rocket science.” We use the Aerospace engineering as a standard for a novel, difficult and highly technical field. However, pricing derivatives is even more novel, less predictable and often no less technical nor difficult. When creating their famous (and from today’s standpoint overly simplistic) option pricing model, Black and Scholes took inspiration straight from the books of aerospace engineers. For all intents and purposes, the asset valuation either IS rocket science or is scarcely less complicated.
Whereas ten years ago the greatest challenge was to develop a proper model to capture the volatility smile, the long-term interest rates or the correlation, now the attention has shifted to capturing the so called XVA and exact profitability of a trade. Participants want to have a price that reflects all costs of each trade, including: counterparty risk, funding, capital requirement and margin, a challenge for the current generation of traders and quants or painful headaches for valuation teams.
There is a number of other significant challenges related to market data that the industry is facing: new curves and a new custom index are only a couple of examples. The time when we could use a single rate curve per currency is long gone, and so is the OIS discounting; now each CSA requires its own curve so that each time, one curve per counterparty and one per currency is needed at the very least.
As we have seen, the valuation rests on a number of assumptions. If its results are to cause more good than harm, it is essential to have an understanding of not only the final value, but also of the process with which it was achieved and what would happen if certain assumptions were relaxed, taking into account the ever changing nature of the financial markets and the fact that many underlying assumptions may change, and some will change, throughout the life of the asset.