Barclays 2011 Annual Report Download - page 236

Notes to the financial statements
For the year ended 31 December 2011 continued
20 Fair value of financial instruments continued
Interest rate products
These are products linked to interest rates or inflation indices. This category includes interest rate and inflation swaps, swaptions, caps, floors, inflation
options, balance guaranteed swaps and other exotic interest rate derivatives. Interest rate products are valued using standard discounted cash flow
techniques.
Interest rate derivative cash flows are valued using interest rate yield curves whereby observable market data is used to construct the term structure of
forward rates. This is then used to project and discount future cash flows based on the parameters of the trade. Instruments with optionality are valued
using a volatility surface constructed from market observable inputs. Exotic interest rate derivatives are valued using industry standard and bespoke
models based on observable market parameters which are determined separately for each parameter and underlying instrument. Where unobservable,
a parameter will be set with reference to an observable proxy. Inflation forward curves and interest rate yield curves are extrapolated beyond observable
tenors.
Balance guaranteed swaps are valued using cash flow models that calculate fair value based on loss projections, prepayment, recovery and discount
rates. These parameters are determined by reference to underlying asset performance, independent research, ABX indices, broker quotes, observable
trades on similar securities and third party pricing sources. Prepayment is projected based on observing historic prepayment.
During 2010, in line with changes in market practice, the methodology for valuing certain collateralised interest rate products was updated to make use
of more relevant interest rate yield curves to discount cash flows. For certain collateralised derivatives, Overnight Indexed Swap (OIS) rates were used
rather than other market reference rates such as LIBOR. During 2011, in line with market practice, the methodology for valuing certain collateralised
interest rate products was further amended to reflect the impact of “cheapest to deliver” collateral on discounting curves, where counterparty CSA
(Credit Support Annex) agreements specify the right of the counterparty to choose the currency of collateral posted.
Commodity products
These products are exchange traded and OTC derivatives based on underlying commodities such as metals, crude oil and refined products, agricultural,
power and natural gas.
The valuations of certain commodity swaps and options are determined using models incorporating discounting of cash flows and other industry
standard modelling techniques. Valuation inputs include forward curves, volatility surfaces and tenor correlation. Within this population, certain forward
curves and volatility surfaces for longer dated exposures are unobservable. These unobservable inputs are set with reference to similar observable
products or by applying extrapolation techniques from the observable market.
Other
This category is largely made up of fixed rate loans, which are valued using models that discount expected future cash flows. These models calculate
fair value based on observable interest rates and unobservable credit spreads. Unobservable credit spreads are determined by extrapolating observable
spreads.
The receivables resulting from the acquisition of the North American businesses of Lehman Brothers is included within ‘Other’. For more details, refer to
Note 31 Legal Proceedings.
Complex derivative instruments
Valuation estimates made by counterparties with respect to complex derivative instruments, for the purpose of determining the amount of collateral to
be posted, often differ, sometimes significantly, from Barclays’ own estimates. In almost all cases, Barclays has been able to successfully resolve such
differences or otherwise reach an accommodation with respect to collateral posting levels, including in certain cases by entering into compromise
collateral arrangements. Due to the ongoing nature of collateral calls, Barclays will often be engaged in discussions with one or more counterparties in
respect of such differences at any given time. Valuation estimates made by counterparties for collateral purposes are, like any other third-party
valuation, considered when determining Barclays’ own fair value estimates.
Fair value adjustments
The main valuation adjustments required to arrive at a fair value are described below:
Bid-Offer valuation adjustments
For assets and liabilities where the firm is not a market maker, mid prices are adjusted to bid and offer prices respectively. Bid-offer adjustments reflect
expected close out strategy and, for derivatives, the fact that they are managed on a portfolio basis. The methodology for determining the bid-offer
adjustment for a derivative portfolio will generally involve netting between long and short positions and the bucketing of risk by strike and term in
accordance with hedging strategy. Bid-offer levels are derived from market sources, such as broker data. For those assets and liabilities where the firm is
a market maker and has the ability to transact at, or better than, mid price (which is the case for certain equity, bond and vanilla derivative markets), the
mid price is used, since the bid-offer spread does not represent a transaction cost.
Uncertainty adjustments
Market data input for exotic derivatives may not have a directly observable bid offer spread. In such instances, an uncertainty adjustment is applied as a
proxy for the bid offer adjustment. An example of this is correlation risk where an adjustment is required to reflect the possible range of values that
market participants apply. The uncertainty adjustment may be determined by calibrating to derivative prices, or by scenario analysis or historical
analysis.
234 Barclays PLC Annual Report 2011 www.barclays.com/annualreport