What’s Fair About This Value?

FX & Energy Derivative Valuations

Michael Corley and Phil Weeber

TEXPO – April 3-5, 2011

Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of a energy derivatives

 Common valuation pitfalls

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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 Continuum

Reliable/Verifiable Subjective/Less Reliable
Level 1 Level 2 Level 3
Quoted Prices in Valuation Techniques – Valuation Techniques –
Active Markets Observable Inputs Unobservable Inputs
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of natural gas derivative

 Common valuation pitfalls

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Valuation Building Blocks
Discounting Future Cash Flows

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

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 PV = FV
(1+i)n

– 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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Valuation Building Blocks
Discounting Future Cash Flows

 Markets provide rates for standard contracts and for spot starting
structures
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Valuation Building Blocks
Applying the Forward Curve

 Market data is used to construct the forward curve

 Cash flows at different points in time will be discounted at

different discount rates

6.0%
5.0%
4.0%
3.0%
2.0%
1-month LIBOR Forward Curve
1.0%
0.0%
Apr-11

Apr-12

Apr-13

Apr-14

Apr-15

Apr-16

Apr-17

Apr-18

Apr-19

Apr-20

Apr-21
Session Overview

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of energy derivatives

 Common valuation pitfalls

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Valuation of Forward Contracts
A Foreign Exchange Contract

 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

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Valuation of Forward Contracts
A Foreign Exchange Contract

 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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Valuation of Forward Contracts
A Foreign Exchange Contract

10,000,000 MXN
MEXCO TEXCO

Widgets

$819,672 10,000,000 MXN

Bank

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

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Valuation of Forward Contracts
A Foreign Exchange Contract

 The currency exchange rate will change over time

 EUR-USD rates have risen  The USD has weakened versus

and fallen by 20% in less JPY for the past 5 years with
than 6 months 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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Valuation of Forward Contracts
A Foreign Exchange Contract

 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.

12.70
USD-MXN on Trade Date
12.60
12.50 USD-MXN on June 30
12.40
12.30
12.20
12.10
12.00
Apr-11

Oct-11

Apr-12
Jun-11

Dec-11
Aug-11

Feb-12
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Valuation of Forward Contracts
A Foreign Exchange Contract

 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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Valuation of Forward Contracts
A Foreign Exchange Contract

 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

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of energy derivatives

 Common valuation pitfalls

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Valuation of Energy Derivatives
Diesel Fuel Swaps

 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.

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Valuation of Energy Derivatives
Diesel Fuel Swaps

 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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Valuation of Energy Derivatives
Diesel Fuel Swaps

 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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Valuation of Energy Derivatives
Diesel Fuel Swaps

$3.1273

Mining Co. Bank

Platts’ Gulf Coast

Diesel Fuel Spot Price

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Valuation of Energy Derivatives
Diesel Fuel Swaps

 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

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Valuation of Energy Derivatives
Diesel Fuel Swaps

 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

 What is a Fair Value?

 Valuation building blocks

 Valuation of a currency forward

 Valuation of energy derivatives

 Common valuation pitfalls

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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

Michael Corley Phil Weeber

President Director, Hedge Advisory
T: 713.844.6384 T: 484.731.0241

Mercatus Energy Advisors Chatham Financial

3333 Richmond Ave, Suite 300
Houston, TX 77098
Main: 713.970.1003
Fax: 713.481.8387
www.MercatusEnergy.com
235 Whitehorse Lane
Kennett Square, PA 19348
Main: 610.925.3120
Fax: 610.925.3125
www.ChathamFinancial.com

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