Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 5 • Each company should use a tenor that is considered to be liquid and appropriate to the risk factor as each commodity is different and markets change. When one or more of these preconditions do not exist, judgment must be applied in considering the relevance and reliability of the market-related information that is available to determine the best estimate of fair value. A position can also be said to be MTM if it is a combination of underlying products/instruments, each of which is actively traded, but it is evaluated using a technique that is standard and widely applied in the marketplace. The most common technique is interpolation, whereby the value is derived from a market source. One example is a three- month forward contract valued from a quarterly market quote. Although the price is quoted in a quarterly strip, the individual months are interpolated from the data available. Another example is an OTC option on natural gas, with a strike for which there may not be a readily available market quote. Nevertheless, the underlying position is actively traded and the option valuation is derived from similar transactions and strikes for which direct market quotes are available. In such instances, the fair-value estimation process can be said to be following a MTM approach. In marking a transaction to market, the contractual volume is multiplied by the difference between the contractual price and the current market price. Generally, companies obtain the current market price from a broker, an electronic trading platform, a publication (e.g., Inside FERC, Gas Daily), or on an exchange (e.g., NYMEX). If the transaction is a purchase and the market price is greater than the contractual price, the company would recognize an unrealized gain on the transaction. Similarly, if the transaction is a purchase and the market price is less than the contractual price, the company would recognize an unrealized loss on the transaction. 1.2 Mark-to-Model MTMO valuation is a means for estimating the fair value of a transaction, position, asset, or portfolio given either or both of the following preconditions: • Direct market quotes of the underlying are not available, so a model is built for developing the prices. For example, in power transactions the forward curve can be extended beyond the normally quoted strip of prices. • The transaction is a complex combination of traded instruments or products and may also incorporate operational and other contractual constraints. In estimating fair value of a transaction using MTMO, the transaction parameters and the market assumptions are input into the model and the value is calculated. The model can be internally designed or obtained through a vendor, depending on the type and complexity of the transaction. Example models that could be used for valuing MTMO transactions can be found in Appendix C. The approach to evaluating the change in economic/fair value or unrealized P&L for a transaction where MTMO valuation is employed is identical to that described for the example