Fair Value of Financial Instruments

The Company’s financial instruments recorded at fair value have been categorized based upon a fair value hierarchy in accordance with accounting guidance, as described in Footnote 3 “Significant Accounting Policies.” The following fair value hierarchy table presents information about the Company’s financial assets and liabilities measured at fair value (in thousands):



	Assets and Liabilities Measured at Fair Value on a Recurring Basis
June 30, 2013	Level 1		Level 2		Level 3		Total
Assets
Financial instruments owned, at fair value:
Equities (1)	$	1,609,957	$	—	$	—	$	1,609,957
U.S. government and Non-U.S. government obligations	24,006		—		—		24,006
Corporate debt	114,724		—		—		114,724
Listed equity options	188,166		—		—		188,166
Loan inventory	—		130,635		—		130,635
Foreign currency forward contracts	—		1,076				1,076
Securitized HECM loan inventory (2)	—		5,327,418		—		5,327,418
Total Financial instruments owned, at fair value	1,936,853		5,459,129		—		7,395,982
Securities on deposit with clearing organizations (3)	155,203		—		—		155,203
Deferred compensation investments (4)	—		21,231		—		21,231
Investment in Deephaven Funds (4)	—		1,327		—		1,327
Total fair value of financial instrument assets	$	2,092,056	$	5,481,687	$	—	$	7,573,743
Liabilities
Financial instruments sold, not yet purchased, at fair value:
Equities (1)	$	1,290,401	$	—	$	—	$	1,290,401
U.S. government obligations	33,532		—		—		33,532
Corporate debt	56,889		—		—		56,889
Listed equity options	132,161		—		—		132,161
Total Financial instruments sold, not yet purchased, at fair value	1,512,983		—		—		1,512,983
Liability to GNMA trusts, at fair value (2)	—		5,284,303		—		5,284,303
Total fair value of financial instrument liabilities	$	1,512,983	$	5,284,303	$	—	$	6,797,286

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(1)	Equities of $621.0 million have been netted by their respective CUSIP number and their long and short positions.


(2)	Represents HECMs that have been securitized into HECM Mortgage Backed Securities (“HMBS”) where the securitization is not accounted for as a sale of the underlying HECMs. See Securitized HECM loan inventory below for full description.


(3)	Securities on deposit with clearing organizations consist of U.S. government obligations and are recorded within Receivable from brokers, dealers and clearing organizations on the Consolidated Statements of Financial Condition.


(4)	Deferred compensation investments and investment in the Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition.



	Assets and Liabilities Measured at Fair Value on a Recurring Basis
December 31, 2012	Level 1		Level 2		Level 3		Total
Assets
Financial instruments owned, at fair value:
Equities (1)	$	1,463,916	$	—	$	—	$	1,463,916
U.S. government and Non-U.S. government obligations	34,339		—		—		34,339
Corporate debt (2)	76,818		—		—		76,818
Listed equity options	202,091		—		—		202,091
Loan inventory	—		191,712		—		191,712
Purchased call options	—		237		—		237
Securitized HECM loan inventory (3)	—		4,054,905		—		4,054,905
Total Financial instruments owned, at fair value	1,777,164		4,246,854		—		6,024,018
Securities segregated under federal and other regulations (4)	3,000		—		—		3,000
Securities on deposit with clearing organizations (4)	182,280		—		—		182,280
Deferred compensation investments (5)	—		21,339		—		21,339
Investment in Deephaven Funds (5)	—		1,342		—		1,342
Assets of business held for sale:
Mortgage-backed securities	—		108,999		—		108,999
Corporate debt	29,690		—		—		29,690
Total fair value of financial instrument assets	$	1,992,134	$	4,378,534	$	—	$	6,370,668
Liabilities
Financial instruments sold, not yet purchased, at fair value:
Equities (1)	$	1,164,999	$	—	$	—	$	1,164,999
U.S. government obligations	71,728		—		—		71,728
Corporate debt (2)	47,263		—		—		47,263
Listed equity options	155,942		—		—		155,942
Embedded conversion derivative	—		237		—		237
Foreign currency forward contracts	—		5,268		—		5,268
Total Financial instruments sold, not yet purchased, at fair value	1,439,932		5,505		—		1,445,437
Liability to GNMA trusts, at fair value (3)	—		4,002,704		—		4,002,704
Liabilities of business held for sale:
Corporate debt	22,858		—		—		22,858
U.S. government obligations	176,309		—		—		176,309
Total fair value of financial instrument liabilities	$	1,639,099	$	4,008,209	$	—	$	5,647,308

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(1)	Equities of $676.8 million have been netted by their respective CUSIP number and their long and short positions.


(2)	Corporate debt of $0.1 million has been netted by respective CUSIP number and their long and short positions.


(3)	Represents HECMs that have been securitized into HMBS where the securitization is not accounted for as a sale of the underlying HECMs. See Securitized HECM loan inventory below for full description.


(4)	Securities segregated under federal and other regulations and Securities on deposit with clearing organizations consist of U.S. government obligations. The securities on deposit with clearing organizations are recorded within Receivable from brokers, dealers and clearing organizations on the Consolidated Statements of Financial Condition.


(5)	Deferred compensation investments and investment in the Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition.

The Company’s equities, listed equity options, U.S. government and Non-U.S. government obligations, rated corporate debt, and actively traded mortgage-backed securities will generally be classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency.

The types of instruments that trade in markets that are not considered to be active, but are valued based on observable inputs such as quoted market prices or alternative pricing sources with reasonable levels of price transparency are generally classified within Level 2 of the fair value hierarchy.

Certain instruments are classified within Level 3 of the fair value hierarchy because they trade infrequently and therefore have little or no price transparency. For those instruments that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. As of June 30, 2013 and December 31, 2012, the Company did not hold any financial instruments that met the definition of Level 3.

The Company’s assets measured at fair value on a nonrecurring basis solely relates to goodwill and intangible assets arising from various acquisitions which would be classified as Level 3 within the fair value hierarchy. See Footnote 11 “Goodwill and Intangible Assets” for additional information.

There were no transfers of financial instruments between levels of the fair value hierarchy for any periods presented.

As of June 30, 2013 and December 31, 2012, the Company’s loan inventory, foreign currency forward contracts, certain mortgage-backed securities, purchased call options and embedded conversion derivative related to its long-term debt (see Footnote 12 “Long-Term Debt”), deferred compensation investments and its remaining investment in the Deephaven Funds are classified within Level 2 of the fair value hierarchy.

The following is a description of the valuation basis, techniques and significant inputs used by the Company in valuing its Level 2 assets and liabilities:

Loan inventory

The Company’s loan inventory primarily comprises newly issued HECMs that it has originated or purchased and for which the Company has elected to account for at fair value. Significant inputs that are used in determining fair value include LIBOR and U.S. treasury interest rates, weighted average coupon and pricing of actively-traded HMBS and dealer quotations for HECMs.

Securitized HECM loan inventory

Securitized HECM loan inventory comprises HECMs that the Company has securitized into HMBS. The Company has recorded the securitized loans in Financial instruments owned, at fair value and a corresponding liability recorded as Liability to GNMA trusts, at fair value, on its Consolidated Statements of Financial Condition. As of June 30, 2013 and December 31, 2012 all of the HMBS created by the Company has been sold to third parties. Significant inputs that are used in determining fair value include LIBOR and U.S. treasury interest rates, weighted average coupon and pricing of actively-traded HMBS and dealer quotations for HECMs.

Foreign currency forward contracts

At June 30, 2013 and December 31, 2012, the Company had a foreign currency forward contract with a notional value of 75.0 million British pounds which is used to hedge the Company’s investment in its European subsidiary. As of December 31, 2012, the Company also had a foreign currency forward contract with a notional value of 10.3 million Euros, which was used to hedge a Euro denominated strategic investment. This Euro hedge was terminated in the first quarter of 2013. The fair value of these contracts was determined based upon spot foreign exchange rates, LIBOR interest rates and dealer quotations.

Mortgage-backed securities

The Company’s mortgage-backed securities that are not actively traded are priced based upon dealer quotations, prices observed from recently executed transactions and cash flow models that incorporate LIBOR forward interest rates, weighted average coupon, weighted average loan age, loan to value and other observable inputs. Mortgage-backed securities are primarily held within Assets of business held for sale on the Consolidated Statements of Financial Condition. As of June 30, 2013, the Company did not hold any mortgage-backed securities on its Consolidated Statements of Financial Condition.

Purchased call options and embedded conversion derivative

The fair value of the purchased call options and embedded conversion derivative are determined using an option pricing model based on observable inputs such as implied volatility of Knight Common Stock, risk-free interest rate, and other factors. The fair value of each of these instruments was zero at June 30, 2013.

Deferred compensation investments

Deferred compensation investments comprise investments in liquid mutual funds that the Company acquires to hedge its obligations to employees and directors under certain non-qualified deferred compensation arrangements. These mutual fund investments can generally be redeemed at any time and are valued based upon quoted market prices.

Investment in the Deephaven Funds

Investment in the Deephaven Funds represents the Company's residual investment in certain funds that were formerly managed by Deephaven Capital Management. These investments are in the process of liquidation and are valued based upon the fair value of the underlying investments within such funds.

Fair value of derivative instruments

The Company enters into derivative transactions, primarily with respect to making markets in listed domestic options. In addition, the Company enters into derivatives to manage foreign currency exposure and related to its long-term debt (see Footnote 12 “Long-Term Debt”). Cash flows associated with such derivative activities are included in cash flows from operating activities on the Consolidated Statements of Cash Flows, when applicable.

The following tables summarize the fair value of derivative instruments in the Consolidated Statements of Financial Condition and the gains and losses included in the Consolidated Statements of Operations (in thousands):



	Statements of Financial Condition Location	Fair Value as of
	Statements of Financial Condition Location	June 30, 2013		December 31, 2012
Asset Derivatives
Derivative instruments not designated as hedging instruments:	Financial instruments owned, at fair value
Purchased call options		$	—	$	237
Listed equity options ⁽¹⁾		188,166		202,091
		$	188,166	$	202,328
Derivative instruments designated as hedging instruments:	Financial instruments owned, at fair value
Foreign currency forward contracts		$	1,076	$	—
Liability Derivatives
Derivative instruments not designated as hedging instruments:	Financial instruments sold, not yet purchased, at fair value
Embedded conversion derivative		$	—	$	237
Listed equity options ⁽¹⁾		132,161		155,942
Foreign currency forward contracts		—		822
		$	132,161	$	157,001
Derivative instruments designated as hedging instruments:	Financial instruments sold, not yet purchased, at fair value
Foreign currency forward contracts		$	—	$	4,446

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(1)	As of June 30, 2013, the Company held 0.6 million each of long and short listed equity option contracts. As of December 31, 2012, the Company held 0.9 million long and 1.0 million short listed equity option contracts. These contracts are not subject to collateral requirements and are not netted.



	Financial Statements Location	Gain (Loss) Recognized
		For the three months ended June 30,
		2013			2012
Derivative instruments not designated as hedging instruments:
Purchased call options	Investment income and other, net	$	—		$	(4,315	)
Listed equity options ⁽¹⁾	Net trading revenue	(13,217		)	9,784
Embedded conversion derivative	Investment income and other, net	—			4,315
Foreign currency forward contracts	Investment income and other, net	—			400
		$	(13,217	)	$	10,184
Derivative instruments designated as hedging instruments:
Foreign currency forward contracts	Accumulated other comprehensive loss	$	(546	)	$	2,208



	Financial Statements Location	Gain (Loss) Recognized
		For the six months ended June 30,
		2013			2012
Derivative instruments not designated as hedging instruments:
Purchased call options	Investment income and other, net	$	(237	)	$	(9,531	)
Listed equity options (1)	Net trading revenue	(20,970		)	(5,802		)
Embedded conversion derivative	Investment income and other, net	237			9,531
Foreign currency forward contracts	Investment income and other, net	151			197
		$	(20,819	)	$	(5,605	)
Derivative instruments designated as hedging instruments:
Foreign currency forward contracts	Accumulated other comprehensive loss	$	5,795		$	(1,120	)

(1)

Realized gains and losses on listed equity options relate to the Company’s market making activities in such options. Such market making activities also comprise trading in the underlying equity securities with gains and losses on such securities generally offsetting the gains and losses reported in this table. Gains and losses on such equity securities are also included in Net trading revenue on the Company’s Consolidated Statements of Operations.

The gross amounts of assets and liabilities subject to netting and gross amounts offset in the Consolidated Statements of Financial Condition were as follows (in thousands):



June 30, 2013	Gross Amounts Recognized		Gross Amounts Offset in the Statements of Financial Condition		Net Amounts of Assets Presented in the Statements of Financial Condition		Gross Amounts Not Offset in the Statement of Financial Condition				Net Amount
							Financial Instruments		Cash Collateral Received
							Financial Instruments		Cash Collateral Received
Assets
Listed equity options	$	188,166	$	—	$	188,166	$	—	$	—	$	188,166
Foreign currency forward contracts	1,076		—		1,076		—		—		1,076
Securities borrowed	1,158,981		—		1,158,981		1,126,224		—		32,757
Total Assets	$	1,348,223	$	—	$	1,348,223	$	1,126,224	$	—	$	221,999
Liabilities
Listed equity options	$	132,161	$	—	$	132,161	$	—	$	5,499	$	126,662
Securities loaned	626,891		—		626,891		616,826		—		10,065
Financial instruments sold under agreements to repurchase (1)	561,251		—		561,251		561,251		—		—
Total Liabilities	$	1,320,303	$	—	$	1,320,303	$	1,178,077	$	5,499	$	136,727



December 31, 2012	Gross Amounts Recognized		Gross Amounts Offset in the Statements of Financial Condition		Net Amounts of Assets Presented in the Statements of Financial Condition		Gross Amounts Not Offset in the Statement of Financial Condition				Net Amount
							Financial Instruments		Cash Collateral Received
							Financial Instruments		Cash Collateral Received
Assets
Listed equity options	$	202,091	$	—	$	202,091	$	—	$	—	$	202,091
Securities borrowed	1,008,720		—		1,008,720		991,302				17,418
Total Assets	$	1,210,811	$	—	$	1,210,811	$	991,302	$	—	$	219,509
Liabilities
Listed equity options	$	155,942	$	—	$	155,942	$	—	$	8,439	$	147,503
Foreign currency forward contracts	4,446		—		4,446		—		—		4,446
Securities loaned	504,082		—		504,082		500,545		—		3,537
Financial instruments sold under agreements to repurchase (1)	466,487		—		466,487		466,487		—		—
Total Liabilities	$	1,130,957	$	—	$	1,130,957	$	967,032	$	8,439	$	155,486


(1)	Financial instruments sold under agreements to repurchase includes $16.3 million and $111.5 million at June 30, 2013 and December 31, 2012, respectively, recorded within Liabilities within discontinued operations and Liabilities of business held for sale, respectively.