Valuation Risk is the risk that the value of a financial asset realized at disposal or maturity is different from the value placed on it whilst held by an investor or trader. This is most acute where the asset in question is illiquid or thinly traded, and up to date values cannot be easily ascertained by reference to trading activity in liquid markets.
Valuation Risk is inherent and unavoidable for many financial asset classes, and one can never eliminate the risk entirely. The main issue associated with this is how to recognize, classify and subsequently control this risk.
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Valuation Risk is not just important to individual firms, it is mission critical to the functioning of the financial system itself. Appropriate valuations are the cornerstone of many functions in the financial market lifecycle, from trading, settlement, client reporting, performance measurement, collateral management, securities lending, risk management and NAV calculation. Without credible valuation then the whole superstructure of the financial system is built on shifting sands.
The impact of Valuation Risk to firms involved in the system is also critical. Inappropriate valuation of financial instrument holdings – whether mistaken or deliberate – can have major ramifications. These can include regulatory, legal or financial sanctions, loss of reputation, clients and credibility or trading or investment losses which can jeopardize the existence of the firm itself.
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Considering its importance, Valuation Risk is still a relatively underrated issue in many financial firms, especially at a senior level. The typical attitude is that it is an operational issue, and is therefore best left to operations to deal with it. As the preceding quotes imply, however, this is not how it is viewed by the regulatory authorities!
Operationally, valuations tend to be addressed by either using trade prices, counterparty or dealer marks, internal models or prices from third party vendors. Each of these approaches has its pros and cons, and to be used prudently it is necessary to be fully aware of these and ensure that there are controls in place to deal with any shortcomings.
In many cases the staff responsible for implementing this process on a day to day basis do not have the specialist knowledge to appropriately assess these risks or understand some of the often complex data and model issues underlying some of the approaches.
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We are specialists in Valuation Risk with deep domain knowledge of methods, sources, data and processes not available to more general financial consulting and advisory firms. Our Valuation Risk Review is aimed at the Board of Directors of financial firms where the detailed awareness of such risks might be lacking. Its objectives are to:
- Highlight and classify the specific Valuation Risks that the firm faces based on the asset portfolio held and the valuation methods, sources and processes used, and;
- Present recommendations to the Board and senior management how to mitigate these risks and better comply with the regulatory regime the firm faces and overall sound practices for valuation.
Consequent to this review we can also work with valuation operational teams within in a firm to better educate them on Valuation Risk generally, and help to implement any changes required to ensure more robust compliance and best practice.
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