RBS 2011 Annual Report Download - page 358

356 RBS Group 2011
11 Financial instruments - valuation continued
Derivatives
Derivatives are priced using quoted prices for the same or similar
instruments where these are available. However, the majority of
derivatives are valued using pricing models. Inputs for these models are
usually observed directly in the market, or derived from observed prices.
However, it is not always possible to observe or corroborate all model
inputs. Unobservable inputs used are based on estimates taking into
account a range of available information including historic analysis,
historic traded levels, market practice, comparison to other relevant
benchmark observable data and consensus pricing data.
Credit derivatives - APS
The Group purchased credit protection over a portfolio of specified assets
and exposures (covered assets) from HM Treasury. The Group has a
right to terminate the APS at any time provided that the Financial
Services Authority has confirmed in writing to HM Treasury that it has no
objection to the proposed termination. On termination the Group must
pay HM Treasury the higher of the regulatory capital relief received and
£2.5 billion less premiums paid plus the aggregate of amounts received
from the UK Government under the APS. The Group has paid APS
premiums totalling £2,225 million (£125 million in 2011, £700 million in
2010 and £1,400 million in 2009). From 31 December 2011, premiums of
£125 million are payable quarterly until the earlier of 2099 and the date
the Group leaves the Scheme.
The APS is a single contract providing credit protection in respect of the
covered assets. Under IFRS, credit protection is treated either as a
financial guarantee contract or as a derivative financial instrument
depending on the terms of the agreement and the nature of the protected
assets and exposures. The Group has concluded, principally because the
covered portfolio includes significant exposure in the form of derivatives,
that the APS does not meet the criteria to be treated as a financial
guarantee contract. The contract has therefore been accounted for as a
derivative financial instrument. It was recognised initially and measured
subsequently at fair value with changes in fair value recognised in profit
or loss within income from trading activities. There is no change in the
recognition and measurement of the covered assets as a result of the
APS.
For the purpose of the APS, a loss is deemed to have arisen on a
covered asset when that asset has experienced a trigger event which
comprises of failure to pay subject to grace periods, bankruptcy and
restructuring.
Where protection is provided on a particular seniority of exposure, as is
the case with the APS, which requires initial losses to be taken by the
Group, it is termed ‘tranched’ protection. The model being used to value
the APS - a Gaussian Copula model with stochastic recoveries - is used
by the Group to value tranches traded by the exotic credit desk and is a
model that is currently used within the wider market.
The option to exit the APS is not usually present in such tranched trades
and consequently, there is no standard market practice for reflecting this
part of the trade within the standard model framework. The approach that
has been adopted assumes that the Group will not exit the trade before
the minimum level of fees have been paid and at this point it will be clear
whether it should exit the trade or not. The APS derivative is valued as
the payment of the minimum level of fees in return for protection receipts
which are in excess of both the first loss and the total future premiums.
The model primarily uses the following inputs in relation to each individual
non-triggered asset: notional, maturity, probability of default and expected
recovery rate given default. Other key inputs include: the correlation
between the underlying assets; the range of possible recovery rates on
the underlying assets (“alpha”); the size of the first loss. The size of the
first loss is adjusted to reflect both realised and expected losses on
triggered assets as well as the level of expected losses on covered
assets that have been sold, that can be treated as losses for the purpose
of the APS (“loss credits”).
During 2011, refinements were made to the treatment of expected losses
on certain triggered assets following a modification to the trigger events
that apply to some portfolios. The valuation refinement was made to
accurately reflect the impact of the changes. The expected losses arising
on assets that trigger under the modified rules now reflect a range of
possible recovery rates.
The APS protects a wide range of asset types, and hence, the correlation
between the underlying assets cannot be observed from market data. In
the absence of this, the Group determines a reasonable level for this
input. The expected recovery rate given default is based on internally
assessed levels. The probability of default is calculated with reference to
data observable in the market. Where possible, data is obtained for each
asset within the APS, but for most of the assets, such observable data
does not exist. In these cases, this important input is determined from
information available for similar entities by geography and rating. The
approach for doing this was refined during the year in order to accurately
reflect both changes in market conditions and the profile of the portfolio of
covered assets.
As the inputs into the valuation model are not all observable the APS
derivative is a level 3 instrument. The fair value of the credit protection at
31 December 2011 was £(0.2) billion (2010 - £0.6 billion; 2009 - £1.4
billion).
Notes on the consolidated accounts continued