RBS 2011 Annual Report Download - page 360

358 RBS Group 2011
11 Financial instruments - valuation continued
Gap risk products are leveraged trades, with the counterparty's potential
loss capped at the amount of the initial principal invested. Gap risk is the
probability that the market will move discontinuously too quickly to exit a
portfolio and return the principal to the counterparty without incurring
losses, should an unwind event be triggered. This optionality is
embedded within these portfolio structures and is very rarely traded
outright in the market. Gap risk is not observable in the markets and, as
such, these structures are deemed to be level 3 instruments.
Other unique trades are valued using a specialised model for each
instrument and the same market data inputs as all other trades where
applicable. By their nature, the valuation is also driven by a variety of
other model inputs, many of which are unobservable in the market.
Where these instruments have embedded optionality they are valued
using a variation of the Black-Scholes option pricing formula, and where
they have correlation exposure they are valued using a variant of the
Gaussian Copula model. The volatility or unique correlation inputs
required to value these products are generally unobservable and the
instruments are therefore deemed to be level 3 instruments.
Equity derivatives
Equity derivative products are split into equity exotic derivatives and
equity hybrids. Equity exotic derivatives have payouts based on the
performance of one or more stocks, equity funds or indices. Most payouts
are based on the performance of a single asset and are valued using
observable market option data. Unobservable equity derivative trades are
typically complex basket options on stocks. Such basket option payouts
depend on the performance of more than one equity asset and require
correlations for their valuation. Valuation is then performed using industry
standard valuation models, with unobservable correlation inputs
calculated by reference to correlations observed between similar
underlyings.
Equity hybrids have payouts based on the performance of a basket of
underlyings where underlyings are from different asset classes.
Correlations between these different underlyings are typically
unobservable with no market information on closely related assets
available. Where no market for the correlation input exists, these inputs
are based on historical time series.
Interest rate and commodity derivatives
Interest rate and commodity options provide a payout (or series of
payouts) linked to the performance of one or more underlying, including
interest rates, foreign exchange rates and commodities.
Exotic options do not trade in active markets except in a small number of
cases. Consequently, the Group uses models to determine fair value
using valuation techniques typical for the industry. These techniques can
be divided firstly, into modelling approaches and secondly, into methods
of assessing appropriate levels for model inputs. The Group uses a
variety of proprietary models for valuing exotic trades.
Exotic valuation inputs include the correlation between interest rates,
foreign exchange rates and commodity prices. Correlations for more
liquid rate pairs are valued using independently sourced consensus
pricing levels. Where a consensus pricing benchmark is unavailable,
these instruments are classified as level 3.
The carrying value of debt securities in issue is represented partly by
underlying cash and partly through a derivative component. The
classification of the amount in level 3 is driven by the derivative
component and not by the cash element.
Other financial instruments
In addition to the portfolios discussed above, there are other financial
instruments which are held at fair value determined from data which are
not market observable, or incorporating material adjustments to market
observed data.
Notes on the consolidated accounts continued