Derivatives & HedgingAdvisory Services

May 2015

Thomas J. McNulty, FRM

Tom McNulty leads Navigant’s Commodity Derivatives & Hedging Practice from our Houston office. He

began his career with Brown Brothers Harriman & Co. in New York. After completing the Corporate

Finance Analyst Training Program, he was assigned to the Money Desk where he was a Fed Funds and

Eurodollar trader and market maker. Mr. McNulty came to Houston after business school, and served in a

variety of corporate finance, risk management, and treasury roles with Enron International, Duke Energy

International, and Plains All American Pipeline. As an advisor and as a consultant, Mr. McNulty has assisted

roughly two dozen corporate, banking, and private capital firms with the challenges they face in dealing

with complex derivative instruments, including:

Hedge strategyModel designCredit Value Adjustments (“CVA”)Structuring & ExecutionValuationCompliance-Designation and DocumentationReporting (ASC 815)Stress TestingNovation, Sales, Un-windings and Defaults

Over the course of his career in banking, industry, and consulting, Mr. McNulty has valued several hundred

derivative instruments with notional valuations in excess of $9 billion.

Navigant’s Scoping Framework

Ask the Right Questions1. Identify the risks.

• Commodity price volatility

• Foreign exchange rates

• Interest rate curve duration & convexity

• Credit risk

2. Quantify the risks.

3. Develop and draft a written hedge strategy.

4. What needs to be protected?

• Balance Sheet

• Regulatory Capital

• Income Statement

• Cash Flow

5. Execute trades.

6. Fair Value the derivative instruments.

7. Make the CVAs and document them.

8. Maintain proper compliance protocols.

9. Report properly under ASC 815, 820, and 825, and/or IFRS 9 and 13.

10. Actively monitor and manage hedge positions.

Use Advanced Analytical Skills

Navigant uses the very latest in rigorous, Quantitative Finance (“QF”) techniques.

• Monte Carlo Simulation (“MCS”)

• Finite Difference Methods

Make Credit Value Adjustments (“CVA”)

We use all methods to arrive at the best answer for our Clients, not just the easiest one.

• Bond spreads

• Credit Default Swap (“CDS”) quotes

• Moody’s/S&P/Fitch ratings

• Numerical methods

Derivatives & Hedging I

Initial Work

• Develop and model Client’s hedge strategy.• Assist with, or do, model design and construction.• Perform and document Credit Value Adjustments (“CVA”).• Assist Client with structuring & trade execution, as needed.

Derivatives & Hedging II

Ongoing/Recurring Work

• Perform “Day One” or “Time Zero” valuations of hedge portfolio’s derivative instruments, consistent with applicable standards.

• Provide to, or support Client with, recurring valuations.

• Monthly• Quarterly• Annually (not advisable)

• Assist Client with compliance program efforts, especially hedge designation and documentation.

• Guide Client with SEC, CFTC, IRS, and other reporting requirements.

• Design and implement a stress testing program.

Derivatives & Hedging III

Work at the Back End

Novation• Navigant can assist Clients with the challenging novation process

in the event of a merger, acquisition, or divestiture.Sales

• Exit valuations will need to be done-Navigant does this work for its Clients.

Un-windings• In order to negotiate un-windings from the best possible position,

simulations need to be run to find the right valuation and stress points. Navigant will do this for Clients, or at least guide them in the process.

Defaults• In the event of defaults, Navigant stands side-by-side with its

Clients to do the analytical support work that must be done in workouts.

Valuation Services I

Fixed-income products

• Fixed and floating rate instruments, bonds, swaps, caps and floors, FRAs and other delta products.

• Yield, duration and convexity calculations.• Bootstrapping to build up the yield curve from trading bonds and swaps.• Curve stripping - Using reference rates & basis spreads, OIS discounting and

dual-curve stripping, cross-currency basis curves, and calculating the cost of funds.

• Interpolation methods, including piece wise constant forwards, piece wise linear, cubic splines, smart quadratics, quartics, and monontone convex splines.

• Stochastic interest rate models, one and two factors.• Model Calibration - Fitting the yield curve in simple models.• Data analysis - Examining interest rate and yield curve data to find the best

model.

Valuation Services II

Probabilistic methods for interest rates

• Using the Heath, Jarrow and Morton model, & modeling the yield curve.• Determining risk factors of yield curve evolution and optimal volatility structure.• Pricing interest rate derivatives by Monte Carlo Simulation.• The Libor Market Model, and calibrating the reference volatility structure by

fitting to caplet or swaption data.• The SABR Model - Managing volatility risks, smiles, & local volatility models.• Using the SABR model and hedging stability.• The Arbitrage Free SABR model - Reduction to the effective forward equation,

arbitrage free boundary conditions, comparison with historical data, and hedging with the SABR model.

Valuation Services III

Credit risk and credit derivatives

• Structural and Intensity models used for credit risk.• CDS pricing, market approaches, and implied default probability, recovery rates, & default

time modeling.• Synthetic CDO pricing, using the default probability distribution, default correlation,

tranche sensitivity, & pricing spreads.• CDO/copula modeling using XLS spreadsheets.• Correlation and state dependence analysis.• Credit Valuation Adjustment (“CVA”): CVA exposure, modeling exposure, collateral,

wrong way risk, & right way risk.• Risk of default - The hazard rate, the implied hazard rate, the stochastic hazard rate and

credit rating, as well as capital structure arbitrage.• Copulas - Pricing basket credit instruments by simulation.• Statistical methods in estimating default probability - Ratings migration, transition

matrices, and Markov processes.

Valuation Services IV

Stochastic volatility and jump diffusion

• Mean-variance analysis, the Merton model, jump distributions, expectations and worst case analysis.

• Non-probabilistic models - Uncertainty in parameter values versus randomness in variables, & nonlinear equations.

• Static hedging - Hedging exotic target contracts with exchange-traded vanilla contracts, optimal static hedging.

• Advanced Monte Carlo techniques - Low-discrepancy series for numerical quadrature. (We use this for option pricing, speculation, and scenario analysis.)

Valuation Services V

Commodity derivatives

• Speculation using energy derivatives and risk management in energy derivatives.• Cointegration - Modeling long term relationships, and statistical arbitrage using mean

reversion.• Forecasting by using option prices - Volatility forecasting using historical asset prices and

current option prices.• Inserting commodity option prices into ARCH models.• Density forecasting - Criteria for good forecasts, estimating risk-neutral densities from

option prices, & risk-neutral to real-world densities.• Geometric Asian options, continuous• Arithmetic Asian options, continuous• Geometric Asian options, discrete• Commodity Swaptions• Spread options• Mean Reversion models• Multi-Factor models• Convenience Yield models

Our Client-Friendly Pricing

1. Time & Expenses2. Fixed fee3. Notional Value based4. Combination of 1, 2, and/or 3.

Appendix Technical Competencies

Our Software Capabilities

• Excel +VBA• Python• R• C++• MATLAB• Mathematica• Crystal Ball• @RISK

Our Platform Experience

• TriplePoint Commodity XL• Openlink

• Endur• Findur• RightAngle

• Reval Saas TRM

Our Model Capabilities

• Black-Litterman• ARCH• GARCH• Black-Scholes-Merton• BSM ‘76• The Greeks• Black-Derman-Toy• Monte Carlo Simulation• Explicit Finite Difference Methods• Crank-Nicholson• Heath, Jarrow, & Morton• SABR• Barone-Adesi, & Whaley

Contact Information

Thomas J. McNulty, FRMDirector, Valuation and Financial Risk ManagementNavigant Consulting, Inc.713.646.5078thomas.mcnulty@navigant.com