RBS 2011 Annual Report Download - page 359

RBS Group 2011 357
The Group has used the following reasonably possible alternative
assumptions in relation to those inputs that could have a significant effect
on the valuation of the APS:
Correlation: +/- 10%
The correlation uncertainty relates to both the nature of the underlying
portfolio and the seniority of protection. The +/-10% correlation range
looks reasonable in light of market observable correlations of similar
levels of protection seniority, for portfolios of investment grade and high
yield assets.
Range of possible recovery rates on underlying assets (alpha): +/- 10%
The level of alpha used in the valuation of the APS is in line with that
used to value tranches traded by the exotic credit desk and assumes that
the underlying assets have a wide range of potential recovery rates. As
the APS protects a wider range of asset classes than is generally
referenced by exotic credit trades, there is uncertainty in relation to this
approach. A comparison of actual recoveries to expected recoveries
supports the approach adopted and, in light of this, only changes of +/-
10% in the assumed width of this range are considered reasonable.
Credit spreads: +/- 10%
The credit spread uncertainty relates to determining the probability of
default for assets where there is no such observable data in the market.
An analysis of the impact on credit spreads of small changes in the
ratings assumptions in key geographic regions indicated that overall
credit spread movements in the +/- 10% range look reasonable.
Discount curve: +/- 1%
Due to the long-dated contractual maturity of the APS, and the
requirement to pay fixed levels of premiums each year, the valuation is
sensitive to long-term interest rates. Valuation uncertainty arises due to
the illiquidity of such interest rates. An interest rate range of +/- 1% is
considered reasonable.
Loss credits: +/- 10%
The level of expected losses on covered assets that have been sold that
can be treated as losses for the purpose of the APS are assessed by the
Asset Protection Agency. For disposals made by the Group where this
assessment has not been completed, the Group makes an estimate of
the likely assessment for the purpose of valuing of the APS. A range of
+/- 10% in the level of assessment is considered reasonable.
Using the above reasonably possible alternative assumptions, the fair
value of the APS derivative could be higher by approximately £295 million
or lower by approximately £44 million as detailed in the table below.
Sensitivity Favourable
£m
Unfavourable
£m
Correlation +/- 10% 35 (23)
Recover alpha +/- 10% 64 (44)
Spreads +/-10% 5 (5)
Discount curve +/- 1% 48 (34)
Loss credit +/- 10% 2 (2)
Cumulative offset 141 64
Total 295 (44)
Individual sensitivities above have been aggregated and do not reflect the
correlated effect of some of the assumptions as related sensitivities.
Credit derivatives - other
The Group's other credit derivatives include vanilla and bespoke portfolio
tranches, gap risk products and certain other unique trades.
Valuation of single name credit derivatives is carried out using industry
standard models. Where single name derivatives have been traded and
there is a lack of independent data or the quality of the data is weak,
these instruments are classified into level 3. These assets will be priced
using the Group’s standard credit derivative model using a proxy curve
based upon a suitable alternative single name curve, a cash based
product or a sector based curve. Where the sector based curve is used,
the proxy will be chosen taking maturity, rating, seniority, geography and
internal credit review on recoveries into account. Sensitivities for these
instruments will be based upon the selection of reasonable alternative
assumptions which may include adjustments to the credit curve and
recovery rate assumptions.
The bespoke portfolio tranches are synthetic tranches referenced to a
bespoke portfolio of corporate names on which the Group purchases
credit protection. Bespoke portfolio tranches are valued using Gaussian
Copula, a standard method which uses observable market inputs (credit
spreads, index tranche prices and recovery rates) to generate an output
price for the tranche by way of a mapping methodology. In essence this
method takes the expected loss of the tranche expressed as a fraction of
the expected loss of the whole underlying portfolio and calculates which
detachment point on the liquid index, and hence which correlation level,
coincides with this expected loss fraction. Where the inputs to this
valuation technique are observable in the market, bespoke tranches are
considered to be level 2 assets. Where inputs are not observable,
bespoke tranches are considered to be level 3 assets. However, all
transactions executed with a CDPC counterparty are considered level 3
as the counterparty credit risk assessment is a significant component of
these valuations.