RBS 2011 Annual Report Download - page 350

348 RBS Group 2011
11 Financial instruments - valuation continued
Other counterparties
The CVA for all other counterparties is calculated on a portfolio basis
reflecting an estimate of the amount a third party would charge to assume
the credit risk.
Expected losses are applied to estimated potential future exposures
which are modelled to reflect the volatility of the market factors which
drive the exposures and the correlation between those factors. Potential
future exposures arising from vanilla products (including interest rate and
foreign exchange derivatives) are modelled jointly using the Group's core
counterparty risk systems. The majority of the Group's CVA held in
relation to other counterparties arises on these vanilla products. The
exposures arising from all other product types are modelled and
assessed individually. The potential future exposure to each counterparty
is the aggregate of the exposures arising on the underlying product types.
The correlation between exposure and counterparty risk is also
incorporated within the CVA calculation where this risk is considered
significant. The risk primarily arises on trades with emerging market
counterparties where the gross mark-to-market value of the trade, and
therefore the counterparty exposure, increases as the strength of the
local currency declines.
Collateral held under a credit support agreement is factored into the CVA
calculation. In such cases where the Group holds collateral against
counterparty exposures, CVA is held to the extent that residual risk
remains.
CVA is held against exposures to all counterparties with the exception of
the CDS protection that the Group has purchased from HM Treasury, as
part of its participation in the Asset Protection Scheme, due to the unique
features of this derivative.
Bid-offer, liquidity and other reserves
Fair value positions are adjusted to bid or offer levels, by marking
individual cash based positions directly to bid or offer or by taking bid-
offer reserves calculated on a portfolio basis for derivatives exposures.
The bid-offer approach is based on current market spreads and standard
market bucketing of risk.
Risk data are used as the primary sources of information within bid-offer
calculations and are aggregated when they are more granular than
market standard buckets. Bid-offer adjustments for each risk factor
(including delta (the degree to which the price of an instrument changes
in response to a change in the price of the underlying), vega (the degree
to which the price of an instrument changes in response to the volatility in
the price of the underlying), correlation (the degree to which prices of
different instruments move together) and others) are determined by
aggregating similar risk exposures arising on different products.
Additional basis bid-offer reserves are taken where these are charged in
the market. Risk associated with non-identical underlying exposures is
not netted down unless there is evidence that the cost of closing the
combined risk exposure is less than the cost of closing on an individual
basis.
Bid-offer spreads vary by maturity and risk type to reflect different
spreads in the market. For positions where there is no observable quote,
the bid-offer spreads are widened in comparison to proxies to reflect
reduced liquidity or observability. Bid-offer methodologies also
incorporate liquidity triggers whereby wider spreads are applied to risks
above pre-defined thresholds.
Netting is applied on a portfolio basis to reflect the level at which the
Group believes it could exit the portfolio, rather than the sum of exit costs
for each of the portfolio’s individual trades. For example, netting is
applied where long and short risk in two different maturity buckets can be
closed out in a single market transaction at less cost than by way of two
separate transactions (calendar netting). This reflects the fact that to
close down the portfolio, the net risk can be settled rather than each long
and short trade individually.
Vanilla risk on exotic products is typically reserved as part of the overall
portfolio based calculation e.g. delta and vega risk on exotic products are
included within the delta and vega bid-offer calculations. Aggregation of
risk arising from different models is in line with the Group's risk
management practices; the model review control process considers the
appropriateness of model selection in this respect.
Product related risks such as correlation risk, attract specific bid-offer
reserves. Additional reserves are provided for exotic products to ensure
overall reserves match market close-out costs. These market close-out
costs inherently incorporate risk decay and cross-effects (taking into
account how moves in one risk factor may affect other inputs rather than
treating all risk factors independently) that are unlikely to be adequately
reflected in a static hedge based on vanilla instruments. Where there is
limited bid-offer information for a product, the pricing approach and risk
management strategy are taken into account when assessing the
reserve.
Amounts deferred on initial recognition
On initial recognition of financial assets and liabilities valued using
valuation techniques incorporating information other than observable
market data, any difference between the transaction price and that
derived from the valuation technique is deferred. Such amounts are
recognised in profit or loss over the life of the transaction; when market
data becomes observable; or when the transaction matures or is closed
out as appropriate. At 31 December 2011, net gains of £161 million (2010
-£167 million; 2009 - £204 million) were carried forward. During the year,
net gains of £89 million (2010 - £62 million; 2009 - £127 million) were
deferred and £95 million (2010 - £99 million; 2009 - £25 million)
recognised in the income statement.
Notes on the consolidated accounts continued