Barclays 2015 Annual Report Download - page 291

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18 Fair value of assets and liabilities continued
Loss given default (LGD)
LGD represents the expected loss upon liquidation of the collateral as a percentage of the balance outstanding.
In general, a significant increase in the LGD in isolation will translate to lower recovery and lower projected cash flows to pay to the securitisation,
resulting in a movement in fair value that is unfavourable for the holder of the securitised product.
Volatility
Volatility is a key input in the valuation of derivative products containing optionality. Volatility is a measure of the variability or uncertainty in returns
for a given derivative underlying. It represents an estimate of how much a particular underlying instrument, parameter or index will change in value
over time. In general, volatilities will be implied from observed option prices. For unobservable options the implied volatility may reflect additional
assumptions about the nature of the underlying risk, as well as reflecting the given strike/maturity profile of a specific option contract.
In general a significant increase in volatility in isolation will result in a movement in fair value that is favourable for the holder of a simple option, but
the sensitivity is dependent on the specific terms of the instrument.
There may be inter-relationships between unobservable volatilities and other unobservable inputs that can be implied from observation (e.g. when
equity prices fall, implied equity volatilities generally rise) but these are specific to individual markets and may vary over time.
Yield
The rate used to discount projected cash flows in a discounted future cash flow analysis.
In general, a significant increase in yield in isolation will result in a movement in fair value that is unfavourable for the holder of a cash instrument.
Fair value adjustments
Key balance sheet valuation adjustments are quantified below:
2015
£m
2014
£m
Bid-offer valuation adjustments (360) (396)
Other exit adjustments (149) (169)
Uncollateralised derivative funding (72) (100)
Derivative credit valuation adjustments:
– Monolines (9) (24)
– Other derivative credit valuation adjustments (318) (394)
Derivative debit valuation adjustments 189 177
Bid-offer valuation adjustments
The Group uses mid market pricing where it 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). For other financial assets and liabilities, bid-offer adjustments are recorded to reflect the price for
the expected close out strategy. The methodology for determining the bid-offer adjustment for a derivative portfolio involves calculating the net risk
exposure by offsetting long and short positions by strike and term in accordance with the risk management and hedging strategy.
Bid-offer levels are derived from market sources, such as broker data.
Other exit adjustments
Market data input for exotic derivatives may not have a directly observable bid-offer spread. In such instances, an exit adjustment is applied as a
proxy for the bid-offer adjustment. An example of this is correlation risk where an adjustment is applied to reflect the possible range of values that
market participants apply. The exit adjustment may be determined by calibrating to derivative prices, by scenario analysis or historical analysis. Other
exit adjustments have reduced by £20m to £149m respectively as a result of movements in market bid-offer spreads.
Discounting approaches for derivative instruments
Collateralised
In line with market practice, the methodology for discounting collateralised derivatives takes into account the nature and currency of the collateral
that can be posted within the relevant CSA. This CSA aware discounting approach recognises the ‘cheapest to deliver’ option that reflects the ability
of the party posting collateral to change the currency of the collateral.
Uncollateralised
A fair value adjustment of £72m is applied to account for the impact of incorporating the cost of funding into the valuation of uncollateralised and
partially collateralised derivative portfolios and collateralised derivatives where the terms of the agreement do not allow the rehypothecation of
collateral received. This adjustment is referred to as the ‘Funding Fair Value Adjustment’ (FFVA). FFVA has decreased by £28m to £72m mainly as a
result of material trade unwinds and the reduction in the average maturity date of the portfolio as trades tend to maturity.
FFVA is determined by calculating the net expected exposure at a counterparty level and applying a funding rate to these exposures that reflects the
market cost of funding. Barclays’ internal Treasury rates are used as an input to the calculation. The approach takes into account the probability of
default of each counterparty, as well as any mandatory break clauses.
FFVA incorporates a scaling factor which is an estimate of the extent to which the cost of funding is incorporated into observed traded levels. On
calibrating the scaling factor, it is with the assumption that Credit Valuation Adjustments (CVA) and Debit Valuation Adjustments (DVA) are retained
as valuation components incorporated into such levels. The effect of incorporating this scaling factor at 31 December 2015 was to reduce FFVA by
£216m (2014: £300m).
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