RBS 2013 Annual Report Download - page 415
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Notes on the consolidated accounts
413
Valuation hierarchy
There is a process to review and control the classification of financial
instruments into the three level hierarchy established by IFRS 13. Some
instruments may not easily fall into a level of the fair value hierarchy and
judgment may be required as to which level the instrument is classified.
Initial classification of a financial instrument is carried out by the Business
Unit Control team following the principles in IFRS. The Business Unit
Control team base their judgment on information gathered during the IPV
process for instruments which include the sourcing of independent prices
and model inputs. The quality and completeness of the information
gathered in the IPV process gives an indication as to the liquidity and
valuation uncertainty of an instrument.
These initial classifications are reviewed and challenged by GPU and are
also subject to senior management review. Particular attention is paid to
instruments crossing from one level to another, new instrument classes
or products, instruments that are generating significant profit and loss and
instruments where valuation uncertainty is high.
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:
• Bond prices - quoted prices are generally available for government
bonds, certain corporate securities and some mortgage-related
products.
• Credit 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.
• Interest rates - these are principally benchmark interest rates such
as the London Interbank Offered Rate (LIBOR), Overnight Index
Swaps rate (OIS) and other quoted interest rates in the swap, bond
and futures markets.
• Foreign currency exchange rates - there are observable markets
both for spot and forward contracts and futures in the world's major
currencies.
• Equity 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.
• Commodity prices - many commodities are actively traded in spot
and forward contracts and futures on exchanges in London, New
York and other commercial centres.
• Price 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 in the
valuation of certain products such as derivatives with multiple
underlying variables that are correlation-dependent. Volatility and
correlation values are obtained from broker quotations, pricing
services or derived from option prices.
• Prepayment 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.
• Counterparty 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).
• Recovery 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.