Bankruptcy Valuation Considerations with Over the Counter Derivatives

By: John Trefethen, Director & Co-Founder

Valuation is an integral part of the bankruptcy process. Throughout the bankruptcy code there are requirements to value the assets and liabilities of the filing company. Among the most challenging items to value are financial products, in particular financial derivatives. Derivatives can be placed in one of two categories – 1) exchange traded, and 2) over the counter (“OTC”). Last week I discussed considerations related to exchange traded derivatives. This article’s focus will be on over the counter (“OTC”) derivatives. Next week I will wrap-up this series with a discussion on valuing stock options and warrants in a bankruptcy proceeding. An OTC derivative is a financial contract between two or more parties that does not trade on an exchange and which can be tailored to each party’s needs. The most common types of OTC derivatives are swaps, forwards and options. These derivative contracts can be tied to equities, interest rates, a company’s credit, foreign exchanges and commodities. Below is a summary of the underlying items and derivative types you can expect to find in a company’s financial statements.

Valuing OTC derivatives is complex due to the combination of multiple pricing models and data sources needed to complete a valuation. Transparency into the valuation methodology is critical in a bankruptcy to know you can rely on the values used in a bankruptcy filing. For exchange traded derivatives observable prices are readily available. However, for determining the value of an OTC derivative the valuation process is more subjective. Subjectivity can exist from the following situations:

  • Market data is a key input into a derivative’s valuation and is continuously changing throughout the day. The timing of when market data is captured can create a wide divergence in values.

  • Models used for valuation purposes are not standardized and can create differing values.

  • Non-standard (aka exotic) derivatives create unique challenges in valuations and introduce another level of subjectivity that can result in a wide divergence in values.

  • Multiple data providers may provide the same core data, but the actual data provided may differ based on the provider of the data.

  • When viewing values on a dealer’s statement, the dealer may be influenced by their own position which could bias the value they report on the statement.

Having an independent, third-party calculate fair value(s), provide documentation on the valuation methodology, and certify to their reasonableness will give you comfort knowing that you are receiving reliable values that can be used in a bankruptcy proceeding. Independent third-parties that provide valuations must maintain relevant data licenses and agreements with the various exchanges in order to have access to current and accurate market data. They must also work with a pricing system(s) that is validated and reliable. HedgeStar maintains the relevant data licenses and exchange agreements and operates in a state-of-the-art pricing system. Our systems and procedures are vetted annually through independent reviews and audits. HedgeStar values a broad range of financial instruments, from plain vanilla to exotic, and has extensive experience valuing domestic municipal and corporate bonds, international debt, illiquid securities, stock warrants and options, and all forms of interest rate, currency and commodity derivatives. As a leading independent valuation agent, HedgeStar is uniquely qualified to help with bankruptcy proceedings to meet the valuation requirements related to financial assets and liabilities.