INTERNATIONAL: Valuation of OTC Derivatives – ISSA Best Practice Recommendations

Tuesday September 16 2008

The International Securities Services Association (ISSA) has published a best practice document on the verification of valuations of OTC derivatives which are held in regulated investment funds.

This will be considered at next week’s Funds-Axis training course on UCITS III, Eligible Assets and Derivatives

In preparation of the Paper, particular attention was had to the interpretation of the UCITS Eligible Assets Directive requirements that:

`…the reference to reliable and verifiable valuation shall be understood as a reference to a valuation, by the UCITS, corresponding to the fair value…, which does not rely only on market quotations by the counter-party and which fulfils the following criteria:

* The basis for the valuation is either a reliable up-to-date market value of the instrument or, if such a value is not available, a pricing model using an adequate recognized methodology;

* Verification of the valuation is carried out by one of the following:

* An appropriate third party which is independent from the counter-party of the OTC derivative, at an adequate frequency and in such a way that the UCITS is able to check it;

* A unit within the UCITS which is independent from the department in charge of managing the assets and which is adequately equipped for such purpose` .

The Working Group has engaged in collating feedback from industry practitioners (Asset Managers, Investment Banks and Securities Services providers) in terms of how these guidelines have been implemented to date. The outcome of these discussions is a determination of best practice that is included in this document.

Best practice recommendations for the valuation of OTC Derivatives were agreed to be as follows:

Primary Valuation: should be either a third party independently calculated price or a price calculated by an independent unit of the Investment Manager.

Verification of Valuation: should be performed on a weekly basis by comparing the primary valuation versus either a third party independently calculated price or the price calculated by an independent unit of the Investment Manager (depending on which one is used for the primary valuation).

Additional Verification of Valuation: should be performed on a monthly basis using the counterparty price versus the primary valuation.

The full recommendations can be viewed by opening of the attachment.