Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 4 II RISK AND RETURN METRICS This section presents risk and return metrics to value and measure the market risks of energy portfolios for merchant energy activities. Since metrics are designed for specific purposes, they are not applicable in all areas of the business. Accordingly, for each metric we discuss the purpose and applicability, the calculation, and typical outputs where appropriate. The discussion below is presented from an economic valuation and risk analysis point of view and is intended to provide measurement tools to facilitate optimal risk management. Certain of these metrics and the techniques for applying them (e.g., fair value, mark-to-market, and mark- to-model) have corresponding usage in an accounting context. The relevant accounting literature governing fair value accounting has assigned specific, technical definitions to numerous terms and other concepts related to fair value accounting. In this paper, fair value is synonymous with economic valuation. A comprehensive and complete discussion of the accounting requirements associated with fair value and their implications is beyond the scope of this current project and is not an objective of the CCRO. 1.0 Approaches to Fair Value Several valuation techniques are available to reflect the fair value of a transaction, an asset/liability position, or a portfolio. The principal objective of the fair value approach is to capture the best economic estimate of the value of the transaction, position, asset/liability, or portfolio. Fair value can be reflected as a mark-to-market (MTM) value and/or a mark-to-model (MTMO) value. When available, mark-to-market valuation using market indications (either in the form of direct price quotations for the position being valued or market-related information that is useful in estimating the value of the position) is reasonable and appropriate in determining fair value. Limited availability of market indications, such as prices and volatilities, and the complex nature of energy derivatives may require the use of models to arrive at fair value. The following discussion of valuation approaches can be applied to futures, forwards, swaps, and option contracts. 1.1 Mark-to-Market The preconditions for using the MTM approach are the following: • There is a liquid market in which the underlying commodities or instruments are actively traded. • The market is sufficiently deep to accommodate exchange of the positions being evaluated. • The positions or transactions are composed of exposures that are themselves traded in the market.