Barclays 2007 Annual Report Download - page 65

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Business review
Barclays PLC Annual Report 2007 63
Mortgage whole loans
The fair value of mortgage whole loans are determined using observable
quoted prices or recently executed transactions for comparable assets.
Where observable price quotations or benchmark proxies are not available,
fair value is determined using cash flow models where significant inputs
include yield curves, collateral specific loss assumptions, asset specific
prepayment assumptions, yield spreads and expected default rates.
Commercial mortgage backed securities and asset backed securities
Commercial mortgage backed securities and asset backed securities (ABS)
(residential mortgages, credit cards, auto loans, student loans and leases)
are generally valued using observable information. Wherever possible,
the fair value is determined using quoted prices or recently executed
transactions. Where observable price quotations are not available, fair value
is determined based on cash flow models where the significant inputs
may include yield curves, credit spreads, prepayment rates. Securities that
are backed by the residual cash flows of an asset portfolio are generally
valued using similar cash flow models.
The fair value of home equity loan bonds are determined using models
which use scenario analysis with significant inputs including age, rating,
internal grade, and index prices.
Collateralised debt obligations
The valuation of collateralised debt obligations (CDOs) notes is first based
on an assessment of the probability of an event of default occurring due
to a credit deterioration. This is determined by reference to the probability
of event of default occurring and the probability of exercise of contractual
rights related to event of default. The notes are then valued by determining
appropriate valuation multiples to be applied to the contractual cash flows.
These are based on inputs including the prospective cash flow performance
of the underlying securities, the structural features of the transaction and
the net asset value of the underlying portfolio.
Private equity
The fair value of private equity is determined using appropriate valuation
methodologies which, dependent on the nature of the investment, may
include discounted cash flow analysis, enterprise value comparisons with
similar companies, price:earnings comparisons and turnover multiples.
For each investment the relevant methodology is applied consistently
over time.
Own credit on financial liabilities
The carrying amount of financial liabilities held at fair value is adjusted to
reflect the effect of changes in own credit spreads. As a result, the carrying
value of issued notes that have been designated at fair value through
profit and loss is adjusted by reference to the movement in the appropriate
spreads. The resulting gain or loss is recognised in the income statement.
Derivatives
Derivative contracts can be exchange traded or over the counter (OTC).
OTC derivative contracts include forward, swap and option contracts
related to interest rates, bonds, foreign currencies, credit standing of
reference entities, equity prices, fund levels, commodity prices or indices
on these assets.
The fair value of OTC derivative contracts are modelled using a series of
techniques, including closed form analytical formulae (such as the Black-
Scholes option pricing model) and simulation based models. The choice
of model is dependant on factors such as; the complexity of the product,
inherent risks and hedging strategy: statistical behaviour of the underlying,
and ability of the model to price consistently with observed market
transactions. For many pricing models there is no material subjectivity
because the methodologies employed do not necessitate significant
judgement and the pricing inputs are observed from actively quoted
markets, as is the case for generic interest rate swaps and option markets.
In the case of more established derivative products, the pricing models
used are widely accepted and used by the other market participants.
Significant inputs used in these models may include yield curves, credit
spreads, recovery rates, dividend rates, volatility of underlying interest
rates, equity prices or foreign exchange rates and, in some cases, correlation
between these inputs. These inputs are determined with reference to
quoted prices, recently executed trades, independent market quotes
and consensus data.
New, long dated or complex derivative products may require a greater
degree of judgement in the implementation of appropriate valuation
techniques, due to the complexity of the valuation assumptions and the
reduced observability of inputs. The valuation of more complex products
may use more generic derivatives as a component to calculating the
overall value.
Derivatives where valuation involves a significant degree of
judgement include:
–Fund derivatives
Fund derivatives are derivatives whose underlyings include mutual
funds, hedge funds, indices and multi asset portfolios. They are
valued using underlying fund prices, yield curves and available market
information on the level of the hedging risk. Some fund derivatives
are valued using unobservable information, generally where the level
of the hedging risk is not observable in the market. These are valued
taking account of risk of the underlying fund or collection of funds,
diversification of the fund by asset, concentration by geographic sector,
strategy of the fund, size of the transaction and concentration of
specific fund managers.
–Commodity derivatives
Commodity derivatives are valued using models where the significant
inputs may include interest rate yield curves, commodity price curves,
volatility of the underlying commodities and, in some cases, correlation
between these inputs, which are generally observable. This approach
is applied to base metal, precious metal, energy, power, gas, emissions,
soft commodities and freight positions. Due to the significant time
span in the various market closes, curves are constructed using
differentials to a benchmark curve to ensure that all curves are valued
using the dominant market base price.
–Structured credit derivatives
Collateralised synthetic obligations (CSOs)are structured credit
derivatives which reference the loss profile of a portfolio of loans, debts
or synthetic underlyings. The reference asset can be a corporate credit
or an asset backed credit. For CSOs that reference corporate credits
an analytical model is used. For CSOs on asset backed underlyings,
due to the path dependent nature of a CSO on an amortising portfolio
a Monte Carlo simulation is used rather than analytic approximation.
The expected loss probability for each reference credit in the portfolio
is derived from the single name credit default swap spread curve
and in addition, for ABS references, a prepayment rate assumption.
A simulation is then used to compute survival time which allows us
to calculate the marginal loss over each payment period by reference
to estimated recovery rates. Significant inputs include prepayment
rates, cumulative default rates, and recovery rates.
Allowances for loan impairment and other
credit risk provisions
Allowances for loan impairment represent management’s estimate of
the losses incurred in the loan portfolios as at the balance sheet date.
Changes to the allowances for loan impairment and changes to the
provisions for undrawn contractually committed facilities and guarantees
provided are reported in the consolidated income statement as part of the
impairment charge. Provision is made for undrawn loan commitments
and similar facilities if it is probable that the facility will be drawn and result
in recognition of an asset at an amount less than the amount advanced.