Volume 2 — Governance and ControlsGovernance and Controls © Copyright 2002, All rights reserved 20 1.1.3 Origination, Structuring, and Pricing Process Overview While the processes above pertain to standard trading deals, complex deals generally require additional review and approval, as appropriate, from the middle office, back office, and senior management, who assess risk and value deal components appropriately. After the front office meets with the counterparty to initiate the deal, participants from the front, middle, and back offices meet to understand the deal components and develop a valuation structure. This effort is generally led by a structuring group. The primary functions of structuring are to develop a deal structure, characterize risks, and value the deal. The structuring group generally works with the origination group to create structure that optimizes risk-reward profile and is in accordance with corporate guidelines. Based on the defined parameters, the structure group then breaks down the risk components of the deal (credit risk, price risk, volatility risk, commodity risk, etc.) for more detailed analysis. To value the deal, a model is developed or selected, and the assumptions, deal terms, and current market data are entered into the model. Model elements include the cost of operational uncertainties (production, delivery, etc.), cost of liquidity, market risk, swing risk, and other embedded optionality. Once the risk components are valued, the structure is presented to the appropriate levels of the organization for approval and presentation to the customer. Objectives • Value deal components based on risk segregation. • Ensure that deals are structured in a way that is consistent with corporate standards and captures optionality, risk, and asset performance. Best Practices and Controls • Origination or complex deals are presented to all affected areas of the organization (middle office, back office, treasury, credit, legal, and front-office management) for review and approval. • The structure group should not engage in the execution of deals. • In order to fully understand all aspects of the deal and ensure that it falls within risk tolerances, its risks should be disaggregated and analyzed before the deal is completed. • The valuation should be documented on a deal approval sheet (electronic or hard copy). • The middle office should maintain an inventory of all approved models. • Models should be back-tested to ensure validity and monitor performance. • Each model should be thoroughly documented, including an analysis of the financial theory and empirical work upon which it is based (including assumptions, limitations, and intended use). • A model validation report should include checks on the analytical derivation of the model used and any numerical solution procedures and code. • Any changes to the model should be documented and approved by the middle office.