A super-basic, ABCs-type primer on derivative valuations. Not meant to be exhaustive, but to introduce the topic to someone who is curious and wants to dip a toe into the topic of OTC Derivatives and start to get a feel for what they are and how they are used.

1. Derivatives Valuation
Just the Basics
JANUARY 2015 CASSANDRA JOHN

2. Who am I?
Hi, I’m Cassandra.
Some quick facts about me:
► 10 years in financial services: capital markets, buy-
side, ratings, technology vendors, and consulting
► Credit Suisse, Barclays, JP Morgan Chase (Asset
Management, Corporate & Investment Bank),
Moody’s, DTCC/Omgeo
► Worked in Operations, Compliance, Regulatory,
Product Control, IT as a project manager, product
manager, business analyst, and data change
manager
Outside of work
I cook, I like single malt scotches, and I finally have
the travel bug! (9 countries + Asia for 2015)
January 2015 DERIVATIVES VALUATION: THE BASICS2
LinkedIn: www.linkedin.com/in/cassandrajohn
Website: www.cassandrajohn.com
Email: cassandra.john@outlook.com
Twitter: @cabigail2

3. Agenda
January 2015 DERIVATIVES VALUATION: THE BASICS3
What is a Derivative?
Basic Pricing and Valuation
Risk Management
Fair Value Measurement
Current Topics in Derivatives

4. If it looks like a duck…
► A financial instrument that derives its value from a specific reference asset
(stocks, bonds, commodities, currencies, rates)
► Has no intrinsic value of its own
► Can be traded on:
♦ A financial exchange (CME, ICE, Eurex, CBOE, LIFFE)
♦ Over-the-counter
► Can be used for:
♦ “Speculation”, i.e., a guess that the specific reference asset will have a fluctuation which presents
a “profit opportunity”
♦ Hedging, i.e. insurance against the fluctuation of a specific reference asset to provide protection
against a loss
January 2015 WHAT IS A DERIVATIVE?4

5. Types of ducks
► Single Stock Future:
MSFT (Microsoft)
► Stock Index Options:
S&P 500 Index
► Commodity Future:
CBOT-Oats Mar 15 @ 307 6/8
► Vanilla Interest Rate Swap:
FIXED/FLOAT - 5.5%-LIBOR 6m
Reset 6m, Tenor 3 years, USD $10mm
January 2015 WHAT IS A DERIVATIVE?5
Type of Derivative Reference Asset
Equity
Single Stock, Portfolio (basket of
stocks), Stock Index
Commodity
Weather, Hogs, Corn, Soybean, Oil,
Gas, Carbon
FX
EUR/GBP, EUR/USD, AUD/NZD,
USD/JPY
Credit bonds
Asset-backed credit cards, car loans, mortgages
Bond Bond Portfolio, Inflation
Rates
Fed Fund, LIBOR 1-month, LIBOR 1-
year

6. Building Blocks of Pricing
Vanilla Interest Rate Swap (Fixed vs Float)
► Notional (not principle!) amount
► Fixed interest rate
► Floating interest rate
► Tenor (i.e. maturity date)
► Settlement frequency
► Discount Factor
January 2015 BASIC PRICING AND VALUATION6
REFERENCE
ASSETS
SETTLEMENT
FREQUENCY
Floating Leg Payments
Notional
Spread
Fixed Leg
Swap Rate
PV
(present
value)
+= ( )

7. Pricing versus Valuation
January 2015 BASIC PRICING AND VALUATION7
► Agree the PRICE at the beginning of the swap
♦ At the start of the swap, the value should always = 0
♦ Neither the buyer/seller of the swap should be “in” or “out” of money
► Determine VALUE throughout the lifetime of the swap
♦ Daily – Am I up or down from 0 at the end of each day?
♦ Monthly – Am I up or down from 0 for the month?
♦ Quarterly – Am I up or down from 0 for the quarter?
♦ On Reset – What must I pay or receive at the end of this settlement period?
► Calculate P&L (Profit & Loss) throughout the lifetime of the swap
♦ On Reset – What did I pay or how much did I receive after the last settlement
period?
♦ On Termination – What did I pay or how much did I receive for the full lifetime of this
swap +/- any early termination fees?
♦ On Expiration – What did I pay or how much I receive for the full lifetime of this
swap?
Guess
Indicative
Hard
Cash

8. Why Valuation Matters
January 2015 BASIC PRICING AND VALUATION8
As a Speculator and/or Dealer
► Am I on track to book an “unearned” profit or
loss due to speculation?
► Do I need to engage in hedging transactions for
my own speculative trading?
► Is it worth early termination to prevent
compounded losses?
As a Hedgor
► How effective is this transaction against the risk
that I am trying to mitigate?
► Do I need to engage in additional risk
mitigation activities to supplement an
ineffective hedge?
► Is it worth early termination prevent
compounded losses?

9. Definition of Fair Value
January 2015 FAIR VALUE MEASUREMENT9
Fair value is a “rational and unbiased estimate of the potential market price of a good, service, or asset”[1]
Important Considerations
► Valuation of an asset or liability for which a market price cannot be determined
► Fair Value = Rational Price; Market Value = Fair Value +/- divergence due to non-predictable
behavioral anomalies
► Assumes an asset that is carried on a mark-to-market basis (i.e., a historical cost is not available or is
not being used)
► Per IFRS (International Financial Reporting Standards) via IVS 2007 (International Valuation
Standards) it should be used in due diligence exercises (versus that of market value)
► Per FASB (Financial Accounting Standards Board) there are 3 categories for fair value assessments:
Levels 1, 2, and 3 [2]
[1] Fair value. (n.d.). Retrieved December 27, 2014, from http://en.wikipedia.org/wiki/Fair_value
[2] IFRS also has a 3 category- based fair value assessment system (IFRS 7) that is similar in structure and definition to the FASB standard

10. FAS 157: Fair Value Measures
January 2015 FAIR VALUE MEASUREMENT10
► Initially issued September 2006; subsequently subsumed into FASB ASC (Accounting Standards
Codification) Topic 820 (Fair Value Measurement)
► Applicable to US GAAP Accounting
 Quoted prices in active
markets
 Effectively liquid or cash
equivalent
 Complete/considerable
market consensus
 Severely limited/no use of
models for pricing
 Valuation comes from
“market observability” or
comparables
 Thinner, less liquid market
 Market consensus on pricing
is not as strong
 Usage of common/accepted
models (e.g. Black-Scholes,
market credit spreads, etc.)
 Unobservable prices or
comparables
 Highly illiquid market
 Little to no market
consensus
 High reliance on custom
models
 Considered mark-to-
management
1 2 3STOCK FUTURE: MSFT IRS: USD 20YR LIBOR 6M LONGEVITY SWAP
Level 1 Level 2 Level 3
Extremely rational pricing Pricing subject to extreme irrationality

11. Types of Risks
January 2015 RISK MANAGEMENT11
Leverage
/
Notional
Value
COUNTERPARTYContractua
l
Margin/
CollateralMARKET
Politics,
Terrorism,
War,
Natural
Disasters
Market
Downturn ENVIRONMENTALHuman
Error
► Risk is inherent to all derivatives contracts
► Certain risks can be more easily accounted for
and/or mitigated:
♦ Margin / Collateral
♦ Leverage / Notional Value
♦ Contractual
► Certain risks cannot be easily accounted for
and/or mitigated:
♦ Politics, Terrorism, War
♦ Natural Disasters
♦ Human Error

12. Elliott Capital / Argentina
January 2015 CURRENT TOPICS IN DERIVATIVES12
Timeline of Events
► 2002: Argentina defaults on bonds
► 2002: Elliott Capital Management (ECM) bought the 2001 bonds
(at a discount) before/after the default
► Oct 2012: ECM, by issuing an injunction in Ghana based on
litigation court orders in the US and UK, seizes an Argentinian
navy ship
► 2013: Argentina declares that it will not be subject to US court
opinions – will not honor the litigation result to treat old and new
bonds as pari passu
► 2014: Lawsuits by Soros Capital Management and Hayman
Capital Management against BoNY for withholding payments
from Argentina on newer bonds due to Argentina’s failure to
comply
Contractua
l
Margin/
Collateral
Politics,
Terrorism,
War,
Natural
Disasters

13. Elliott Capital / Caesars Entertainment
January 2015 CURRENT TOPICS IN DERIVATIVES13
► Caesars Entertainment Corporation (CZR) is attempting to
restructure $18.4 billion in debt; company has been operating at
a loss since 2009
► Elliott Capital Management (ECM) owns at least 30% of a series
of Caesar’s bond; is encouraging trustee to sue the company to
put it into receivership
► ECM purchased CDS contracts prior to entering into negotiations
with Caesar related to the push to bankruptcy
► CZR 1 YR CDS price has doubled from 43.5% (Sep ‘14) to 79.5%
(Dec ‘14) – 1 year ago, price was 8.75% upfront
► CZR has skipped its most recent $225 million interest payments
on junior bonds to continue restructuring talks; the ISDA
determinations committee is now deliberating whether that
represents a “failure-to-pay” credit event which will trigger
payout on outstanding CDS contracts
Contractua
l
Margin/
Collateral
Market
Downturn

14. Downturn in Oil and Gas
January 2015 CURRENT TOPICS IN DERIVATIVES14
► Oil has a 5-week continuing loss; in June, oil (Brent crude) was at
$115 per barrel – current price is $59.45 a barrel on ICE
♦ Reduced demand in Europe, Asia, and the US due to
weakening economies + efficiency measures
♦ Production level up in the US and Canada due to drilling for
“hard crude” in the North Dakota / Albert shale formations
♦ OPEC continuing existing production levels despite
softening prices; this maintains the downward pressure on
prices
► Natural gas futures have dropped beneath the $3 USD per
million British thermal units (Btus) – lowest price since 2012
♦ Dropped 26% in December
♦ Largest one-month drop since July 2008
♦ Temperatures in the Eastern US above average for
December
♦ High production has removed previous existing shortage;
inventories remain high which will keep prices low
Contractua
l
Market
Downturn
Politics,
Terrorism,
War,
Natural
Disasters

15. Extra Credit
January 2015 ADDITIONAL READING15

16. For the Bookshelf
January 2015 ADDITIONAL READING16
Models.Behaving.Badly. by Emanuel Derman
The Man of Nunbers: Fibonacci’s Arithmetic Revolution by Keith J. Devlin
The Price of Everything by Eduardo Porter
Flash Boys: A Wall Street Revolt by Michael Lewis
Deals from Hell: M&A Lessons That Rise Above the Ashes by Robert F. Bruner