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Adjustments should reflect expected future costs such
as unearned credit spreads, close-out costs, investing
and funding costs, and administrative costs. Most
limited end-users (and some traders) may find it too
costly to establish systems that accurately measure the
necessary adjustments for mid-market pricing. In such
cases, banks may price derivatives based on bid and
offer levels, provided they use the bid side for long
positions and the offer side for short positions. This
procedure will ensure that financial derivatives
positions are not overvalued.
Banks adopting mid-market pricing should recognize that
mid-market prices are not observable for many
instruments. In those cases, banks should derive
unbiased estimates of market prices from prices in
similar markets or from sources that are independent of
the bank’s traders. The bank’s operations staff should
develop procedures to verify the reasonableness of all
pricing variables or, if that is not possible, should
limit the bank’s exposure through position or
concentration limits and develop appropriate reporting
mechanisms.
Traders may review and comment on prices. When
material discrepancies occur, senior management should
review them. If, in an extenuating circumstance,
senior management overrides a back office estimate, it
should prepare a written explanation of the decision.
IV. Adjustments to Midmarket Value
A. Overview
The credit adjustment and the administrative costs
adjustment are the primary adjustments in dispute. The total of
these adjustments in the industry exceeds $1 billion per year.
Dealers during the relevant years also reported adjustments to
midmarket value for the following: (1) Provision for current
closeout costs of net open positions, (2) provision for future
hedging costs (portfolio rebalances), (3) adjustment for odd
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