Barclays 2008 Annual Report Download - page 291

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Financial statements
Barclays PLC Annual Report 2008 289
50 Fair value of financial instruments (continued)
The nature of the valuation techniques set out in the table above are summarised as follows:
Valuations based on observable inputs
Valuations based on observable inputs include
– Financial instruments for which their valuations are determined by reference to unadjusted quoted prices in active markets where the quoted price is
readily available and the price represents actual and regularly occurring market transactions on an arm’s length basis;
– Financial instruments valued using recent arm’s length market transactions or with reference to the current fair value of similar instruments;
– Linear financial instruments such as swaps and forwards which are valued using market standard pricing techniques;
– Options that are commonly traded in markets whereby all the inputs to the market-standard pricing models are deemed observable.
Valuations based on unobservable inputs
Valuations based on unobservable inputs include:
(a) Vanilla products
Products valued using simple models, such as discounted cash flow or Black Scholes models, where some of the inputs are not observable. This would
include, for example, commercial loans, commercial mortgage backed securities, selected mortgage products, Alt As and subprime loans, as well as long-
dated vanilla options with tenors different to those commonly traded in the markets and hence unobservable volatilities.
(b) Exotic products
Exotic products are over-the-counter products that are relatively bespoke, not commonly traded in the markets, and are valued using sophisticated
mathematical models where some of the inputs are not observable.
In determining the value of vanilla and exotic products the following are the principal inputs that can require judgement:
(i) Volatility
Volatility is a critical input to all option pricing models, across all asset classes. In most cases volatility is observable from the vanilla options that are traded
across the various asset classes but, on occasion, volatility is unobservable, for example, for long maturity option.
(ii) Correlation
Across asset classes, correlation is another important input to some pricing models, for example for products whose value depends on two equity indices.
In some developed markets there are products traded from which correlation can be implied, for example spread products in commodities.
(iii) Model input parameters
Some exotic models have input parameters that define the models, for example interest rate models tend to have parameters that are needed to capture
the rich dynamics of the yield curve. These model parameters are typically not directly observable but may be inferred from observable inputs.
(iv) Spreads to discount rates
For certain product types, particularly credit related such as asset backed financial instruments, the discount rate is set at a spread to the standard
discount (LIBOR) rates. In these cases, in addition to standard discount rates, the spread is a significant input to the valuation. For some assets this spread
data can be unobservable.
(v) Default rates and recovery rates
In certain credit products valued using pricing models, default rates and recovery rates may be necessary inputs. Some default rates and recovery rates
are deemed observable but for others which are less frequently traded in the markets they may not be.
(vi) Prepayment rates
For products in the securitisation businesses, for example mortgage backed securities, prepayment rates are key inputs. Some of the drivers of
prepayment are understood (such as the nature of assets/loans, e.g. quality of mortgage pool and macroeconomic factors) however, future prepayment
rates are considered unobservable.
The following summary sets out the principal instruments whose valuation may involve judgmental inputs.
Corporate bonds
Corporate bonds are generally valued using observable quoted prices or recently executed transactions. Where observable price quotations are not
available, the fair value is determined based on cash flow models where significant inputs may include yield curves, bond or single name credit default
swap spreads.
Mortgage whole loans
Wherever possible, the fair value of mortgage whole loans is 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 valued using observable information to the greatest extent possible. 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 and 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.