Barclays 2012 Annual Report Download - page 271

The strategic report Governance Risk review Financial review Financial statements Risk management Shareholder information
18 Fair value of financial instruments continued
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 Group 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.
Credit and debit valuation adjustments
Credit valuation adjustments (CVAs) and debit valuation adjustments (DVAs) are incorporated into derivative valuations to reflect the impact
on fair value of counterparty credit risk and Barclays own credit quality respectively. These adjustments are modelled for OTC derivatives across
all asset classes. Calculations are derived from estimates of exposure at default, probability of default and recovery rates, on a counterparty basis.
Counterparties include (but are not limited to) corporates, monolines, sovereigns and sovereign agencies, supranationals, and special-purpose
vehicles.
Exposure at default for CVA and DVA is generally based on expected exposure, estimated through the simulation of underlying risk factors. For
some complex products, where this approach is not feasible, simplifying assumptions are made, either through proxying with a more vanilla
structure, or using current or scenario-based mark-to-market as an estimate of future exposure. Where strong collateralisation agreement exists
as a mitigant to counterparty risk, the exposure is set to zero.
Probability of default and recovery rate information is generally sourced from the CDS markets. For counterparties where this information is not
available, or considered unreliable due to the nature of the exposure, alternative approaches are taken based on mapping internal counterparty
ratings onto historical or market-based default and recovery information. In particular, this applies to sovereign related names where the effect
of using the recovery assumptions implied in CDS levels would imply a £200m increase in CVA.
Correlation between counterparty credit and underlying derivative risk factors may lead to a systematic bias in the valuation of counterparty credit
risk, termed ‘wrong-way’ or ‘right-way’ risk. This is not incorporated into the CVA calculation, but is monitored regularly via scenario analysis and
has been found to be immaterial.
Model valuation adjustments
Valuation models are reviewed under the firm’s model governance framework. This process identifies the assumptions used and any model
limitations (for example, if the model does not incorporate volatility skew). Where necessary, fair value adjustments will be applied to take these
factors into account. Model valuation adjustments are dependant on the size of portfolio, complexity of the model, whether the model is market
standard and to what extent it incorporates all known risk factors. All models and model valuation adjustments are subject to review on at least an
annual basis.
Own credit adjustments
The carrying amount of issued notes that are designated under the IAS 39 fair value option is adjusted to reflect the effect of changes in own
credit spreads. The resulting gain or loss is recognised in the income statement. For funded instruments such as issued notes, mid-level credit
spreads on Barclays issued bonds are the basis for this adjustment.
At 31 December 2012, the own credit adjustment arose from the fair valuation of Barclays financial liabilities designated at fair value. Barclays
credit spreads tightened during 2012, leading to a charge of £4,579m (2011: gain of £2,708m) from the fair value of changes primarily in own
credit itself but also reflecting the effects of foreign exchange rates, time decay and trade activity.
barclays.com/annualreport Barclays PLC Annual Report 2012 I 269