Barclays 2015 Annual Report Download - page 290

288 I Barclays PLC Annual Report 2015 home.barclays/annualreport
Notes to the financial statements
18 Fair value of assets and liabilities continued
The following section describes the significant unobservable inputs identified in the table above, and the sensitivity of fair value measurement of the
instruments categorised as Level 3 assets or liabilities to increases in significant unobservable inputs. Where sensitivities are described, the inverse
relationship will also generally apply.
Where reliable interrelationships can be identified between significant unobservable inputs used in fair value measurement, a description of those
interrelationships is included below.
Comparable price
Comparable instrument prices are used in valuation by calculating an implied yield (or spread over a liquid benchmark) from the price of a
comparable observable bond, then adjusting that yield (or spread) to derive a value for the unobservable bond. The adjustment to yield (or spread)
should account for relevant differences in the bonds such as maturity or credit quality. Alternatively, a price-to-price basis can be assumed between
the comparable instrument and bond being valued in order to establish the value of the bond.
In general, a significant increase in comparable price in isolation will result in a movement in fair value that is favourable for the holder of a cash
instrument.
For a derivative instrument, a significant increase in an input derived from a comparable price in isolation can result in a movement in fair value that
is favourable or unfavourable depending on the specific terms of the instrument.
Conditional prepayment rate
Conditional prepayment rate is the proportion of voluntary, unscheduled repayments of loan principal by a borrower. Prepayment rates affect the
weighted average life of securities by altering the timing of future projected cash flows.
A significant increase in a conditional prepayment rate in isolation can result in a movement in fair value that is favourable or unfavourable depending
on the specific terms of the instrument.
Conditional prepayment rates are typically inversely correlated to credit spread, i.e. securities with high borrower credit spread typically experience
lower prepayment rates, and also tend to experience higher default rates.
Constant default rate
The constant default rate represents an annualised rate of default of the loan principal by the borrower.
A significant increase in a constant default rate in isolation can result in a movement in fair value that is favourable or unfavourable depending on the
specific terms of the instrument.
Constant default rate and conditional prepayment rates are typically inversely correlated: fewer defaults on loans typically will mean higher credit
quality and therefore more prepayments.
Correlation
Correlation is a measure of the relationship between the movements of two variables (i.e. how the change in one variable influences a change in the
other variable). Correlation is a key input into valuation of derivative contracts with more than one underlying instrument. For example, where an
option contract is written on a basket of underlying names, the volatility of the basket, and hence the fair value of the option, will depend on the
correlation between the basket components. Credit correlation generally refers to the correlation between default processes for the separate names
that make up the reference pool of a CDO structure.
A significant increase in correlation in isolation can result in a movement in fair value that is favourable or unfavourable depending on the specific
terms of the instrument.
Credit spread
Credit spreads typically represent the difference in yield between an instrument and a benchmark security or reference rate. Credit spreads reflect
the additional yield that a market participant would demand for taking exposure to the credit risk of an instrument, and form part of the yield used in
a discounted cash flow calculation.
In general, a significant increase in credit spread in isolation will result in a movement in fair value that is unfavourable for the holder of a cash asset.
For a derivative instrument, a significant increase in credit spread in isolation can result in a movement in fair value that is favourable or unfavourable
depending on the specific terms of the instrument.
Loan spread
Loan spreads typically represent the difference in yield between an instrument and a benchmark security or reference rate. Loan spreads typically
reflect funding costs, credit quality, the level of comparable assets such as gilts and other factors, and form part of the yield used in a discounted
cash flow calculation.
The ESHLA portfolio primarily consists of long dated fixed rate loans extended to counterparties in the UK Education, Social Housing and Local
Authority sectors. The loans are categorised as Level 3 in the fair value hierarchy due to their illiquid nature and the significance of unobservable loan
spreads to the valuation. Valuation uncertainty arises from the long dated nature of the portfolio, the lack of secondary market in the loans and the
lack of observable loan spreads. The majority of ESHLA loans are to borrowers in heavily regulated sectors that are considered extremely low credit
risk, and have a history of zero defaults since inception. While the overall credit spread range is 991bps (2014: 961bps), the vast majority of spreads
are concentrated towards the bottom end of this range, with 99% of the loan notional being valued with spreads less than 200bps, consistently for
both years.
In general, a significant increase in loan spreads in isolation will result in a movement in fair value that is unfavourable for the holder of a loan.
Forwards
A price or rate that is applicable to a financial transaction that will take place in the future. A forward is generally based on the spot price or rate,
adjusted for the cost of carry, and defines the price or rate that will be used to deliver a currency, bond, commodity or some other underlying
instrument at a point in the future. A forward may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan
payment. In general, a significant increase in a forward in isolation will result in a movement in fair value that is favourable for the contracted receiver
of the underlying (currency, bond, commodity, etc), but the sensitivity is dependent on the specific terms of the instrument.