• Welcome
• Hedge Fund Valuations: Leading the Way with Complex Pricing
• Checking the Model, Refining the Data
• Pricing for the Traditional Manager

Welcome

Richard Ernesti
Managing Director, Global Head of Investor Services
Global Transaction Services, Citi

Over the past year, pricing has fallen increasingly under the spotlight, especially for more hard-to-value instruments.

Much of this is due to the fact that a number of leading hedge funds were exposed with highly leveraged portfolios full of hard-to-value instruments.

The events of the past year have shifted many investors' priorities as they demand proof of visibility and control as well as a guarantee that their money is being managed properly.

The need for robust risk management within the modern financial services industry cannot be overstated with many believing it to be the single biggest issue facing the marketplace.

For every manager, alternative and traditional, independent valuations are a must. But so is the ability to analyse, compare and question the prices, models and controls.

Investment managers whose administrators capably straddle the long/short divide and who possess these skills, like Citi, are well positioned to capitalise on the opportunities that emerge as the industry rebuilds.

Below, Hugh Hanna and Roger Boyd, from Alternative Investment Administration Services at Citi's Global Transaction Services, discuss how Citi's dedicated complex pricing team are effectively acting as an additional layer of risk management, asking tough questions of pricing counterparties.

Hedge Fund Valuations: Leading the Way with Complex Pricing

Hugh Hanna
Head of Global Data Services, Alternative Investment Administration Services
Global Transaction Services, Citi

The valuation of complex Over-The-Counter (OTC) derivatives has been under the spotlight for the past year. Commentators note that the practice of marking-to-market has sometimes been 'marking-to-myth'.

Investors are increasingly wary of pricing that only relies on counterparties. For hedge funds keen to retain the confidence of investors, it has never been more important to demonstrate transparency in the valuation of OTC instruments.

Citi has long led the way in the provision of independent valuations for OTC derivatives and hard-to-price securities. Set up in 2003 as a response to the growing number of client traded credit derivatives, our fund accounting clients have been afforded with an extra layer of risk management via Citi's Complex Pricing Group (CPG).

Made up of dedicated analysts with experience in finance, economics and mathematics, the team has the ability to reverse-engineer OTC derivatives by drilling down into the underlying structure to question or validate its pricing.

Located in Dublin, the CPG services Citi's clients around the world. It prices complex funds, dealing with more than 20,000 OTC positions. Valuations are provided on a monthly, weekly or daily basis.

It sources data from an ever-expanding range of independent valuation providers, using scrubbed prices to ensure deep and transparent coverage.

Those prices are compared with secondary pricing sources, such as those from an Investment Manager. Where differences exceed pre-determined tolerance levels, an analyst reviews the underlying market data and valuation model to determine the root of any price challenge.

For Citi clients this is an invaluable service. In the instance of a price challenge, the skill set of a derivatives specialist is essential to performing a 'deep-dive' analysis and provide an objective and informed view. Moreover, there are certain complex derivatives, such as correlation swaps or equity variance swaps, where the CPG can have access to more data than the client.

With access to a full range of forward curves, volatility surfaces and currency pairs, the Team can independently value a position or reverse engineer a valuation, decomposing an instrument into its constituent parts.

Above all, the client has somebody that speaks their own language while end-investors know that their fund does not have to rely on just counterparty prices.

As the range of instruments has expanded, so the team has widened the number of independent valuation providers it uses. At Citi we see it as part of our job to source and evaluate new vendors. We act as a quality filter, saving our clients time and acting as a second review of their vendor evaluations.

Staying ahead of the game is vital. Within the CPG is an Analysis and Research unit, which proactively focuses on new instruments and models while keeping abreast of industry developments. Citi shares this data with our clients, particularly traders, so they are fully informed and can make the right decisions immediately.

For example, where we find a client trading in a new instrument type for which there is no independent valuation available, the unit will liaise with valuation vendors to develop independent pricing.

The events of recent months have made independent pricing even more relevant than before. Citi is a market leader in the provision, analysis and comparison of independent valuations and, if necessary, we can check models and decompose structures.

Checking the Model, Refining the Data

Roger Boyd
Vice President, Complex Pricing Group, Alternative Investment Administration Services
Global Transaction Services, Citi

The Complex Pricing Group (CPG) checks both the integrity of the data used by valuation providers and the acceptability of the models used by such companies chosen to provide independent valuation.

It has been instrumental in improving the independent valuation processes on a number of occasions.

In one instance, the team questioned the recovery rate assumptions used by a fund client for a particular credit default swap (CDS). A market default recovery rate of 40% was being used as a standard, but this element of a CDS valuation is dynamic and pricing should reflect market conditions. An exploratory conversation with the client resulted in a change to their valuation process when the CPG was able to highlight potential weaknesses in their approach.

In another situation, Citi's CPG team improved a valuation vendor's approach to pricing a long-dated equity variance swap - essentially a bet on market volatility.

Finally, one of our largest investment management clients had taken out a ten-year equity variance swap and the instrument was proving very difficult to value due to the absence of pertinent market data. In this instance, the vendor was providing daily quotes from monthly observations of volatility. Following a discussion with the vendor and the client it was agreed that such observations would not be acceptable. Citi's CPG independently reverse engineered the vendor price, highlighting the root of the price challenge to the client and valuation agent.

This resulted in the vendor agreeing to make more frequent volatility observations, a resulting in more accurate valuation.

Pricing for the Traditional Manager

Steve Caluwaerts
Head of Fund Administration EMEA
Global Transaction Services, Citi

As the lines between the alternative and traditional funds businesses become increasingly blurred, traditional managers must have an administrator with the expertise to meet their, and the market's, expectations.

At Citi we understand traditional managers require the services of a proven fund accountant with pricing expertise across every asset class, from equities and bonds to listed derivatives. Not just OTCs and complex instruments.

Our dedicated pricing team have a long history of servicing traditional managers. As well as the transparency requirements posed by the regulators, we fully understand risk cannot be distilled into a single number and that having access to the latest, most accurate pricing is not enough. Moreover, we now reside in an environment where investors' have lifted the bar on standards around transparency, risk management and reporting. Simple 'cut and paste' prices are just not enough; the ability to question the prices is paramount.

We help our clients actively question and compare the information emerging from multiple data vendors by scrubbing the prices provided and applying over 40 valuation controls. We then apply each client's specific risk management rules to ensure no price goes unchallenged. Only when a price has passed through these controls will the decision to accept a price be made.

This entire process is underpinned by our harmonised global operating platform which integrates seamlessly with each clients' systems to provide a consistent level of reporting and data across the full breadth of fund types and legal vehicles. As part of this same system we provide, as standard: multi-class, multi-currency and intra-day net asset valuations; complete and bespoke data reconciliation; and financial reporting.

Combined with Citi's unique ability to service the complete suite of investment solutions across the entire investment value chain, we ensure our clients can maximise their presence while leveraging our local and global strengths in execution, comprehensive custody and fund administration services, and our leadership in prime finance, so managers can meet the demands of their investors and the market.