RBS 2011 Annual Report Download - page 348

346 RBS Group 2011
11 Financial instruments - valuation continued
Valuation techniques
The Group derives fair value of its instruments differently depending on
whether the instrument is a non-modelled or a modelled product.
Non-modelled products
Non-modelled products are valued directly from a price input and are
typically valued on a position by position basis and include cash, equities
and most debt securities.
Modelled products
Modelled products are those that are valued using a pricing model,
ranging in complexity from comparatively vanilla products such as
interest rate swaps and options (e.g. interest rate caps and floors)
through to more complex derivatives. The valuation of modelled products
requires an appropriate model and inputs into this model. Sometimes
models are also used to derive inputs (e.g. to construct volatility
surfaces). The Group uses a number of modelling methodologies.
Inputs to valuation models
Values between and beyond available data points are obtained by
interpolation and extrapolation. When utilising valuation techniques, the
fair value can be significantly affected by the choice of valuation model
and by underlying assumptions concerning factors such as the amounts
and timing of cash flows, discount rates and credit risk. The principal
inputs to these valuation techniques are as follows:
xBond prices - quoted prices are generally available for government
bonds, certain corporate securities and some mortgage-related
products.
xCredit spreads - where available, these are derived from prices of
credit default swaps or other credit based instruments, such as debt
securities. For others, credit spreads are obtained from pricing
services.
xInterest rates - these are principally benchmark interest rates such
as the London Interbank Offered Rate (LIBOR) and quoted interest
rates in the swap, bond and futures markets.
xForeign currency exchange rates - there are observable markets
both for spot and forward contracts and futures in the world's major
currencies.
xEquity and equity index prices - quoted prices are generally readily
available for equity shares listed on the world's major stock
exchanges and for major indices on such shares.
xCommodity prices - many commodities are actively traded in spot
and forward contracts and futures on exchanges in London, New
York and other commercial centres.
xPrice volatilities and correlations - volatility is a measure of the
tendency of a price to change with time. Correlation measures the
degree which two or more prices or other variables are observed to
move together. If they move in the same direction there is positive
correlation; if they move in opposite directions there is negative
correlation. Volatility is a key input in valuing options and the
valuation of certain products such as derivatives with more than one
underlying variable that are correlation-dependent. Volatility and
correlation values are obtained from broker quotations, pricing
services or derived from option prices.
xPrepayment rates - the fair value of a financial instrument that can
be prepaid by the issuer or borrower differs from that of an
instrument that cannot be prepaid. In valuing prepayable
instruments that are not quoted in active markets, the Group
considers the value of the prepayment option.
xCounterparty credit spreads - adjustments are made to market
prices (or parameters) when the creditworthiness of the counterparty
differs from that of the assumed counterparty in the market price (or
parameters).
xRecovery rates/loss given default - these are used as an input to
valuation models and reserves for asset-backed securities and other
credit products as an indicator of severity of losses on default.
Recovery rates are primarily sourced from market data providers or
inferred from observable credit spreads.
The Group may use consensus prices for the source of independent
pricing for some assets. The consensus service encompasses the equity,
interest rate, currency, commodity, credit, property, fund and bond
markets, providing comprehensive matrices of vanilla prices and a wide
selection of exotic products. GBM and Non-Core contribute to consensus
pricing services where there is a significant interest either from a
positional point of view or to test models for future business use. Data
sourced from consensus pricing services is used for a combination of
control processes including direct price testing, evidence of observability
and model testing. In practice this means that the Group submits prices
for all material positions for which a service is available.
In order to determine a reliable fair value, where appropriate,
management applies valuation adjustments to the pricing information
gathered from the above sources. These adjustments reflect the Group's
assessment of factors that market participants would consider in setting a
price. Furthermore, on an ongoing basis, the Group assesses the
appropriateness of any model used. To the extent that the price provided
by internal models does not represent the fair value of the instrument, for
instance in highly stressed market conditions, the Group makes
adjustments to the model valuation to calibrate to other available pricing
sources. Where unobservable inputs are used, the Group may determine
arange of possible valuations derived from differing stress scenarios to
determine the sensitivity associated with the valuation. When establishing
the fair value of a financial instrument using a valuation technique, the
Group considers certain adjustments to the modelled price which market
participants would make when pricing that instrument. Such adjustments
include the credit quality of the counterparty and adjustments to
compensate for any known model limitations.
Notes on the consolidated accounts continued