TD Bank 2014 Annual Report Download - page 145

TD BANK GROUP ANNUAL REPORT 2014 FINANCIAL RESULTS 143
At initial recognition, debt securities classified as loans do not
include securities with quoted prices in active markets. When quoted
market prices are not readily available, fair value is based on quoted
market prices of similar securities, other third-party evidence or by
using a valuation technique that maximizes the use of observable
market inputs. If quoted prices in active markets subsequently become
available, these are used to determine fair value for debt securities
classified as loans.
The fair value of loans carried at fair value through profit or loss,
which includes trading loans and loans designated at fair value
through profit or loss, is determined using observable market prices,
where available. Where the Bank is a market maker for loans traded
in the secondary market, fair value is determined using executed prices,
or prices for comparable trades. For those loans where the Bank is not
a market maker, the Bank obtains broker quotes from other reputable
dealers, and corroborates this information using valuation techniques
or by obtaining consensus or composite prices from pricing services.
Commodities
The fair value of physical commodities is based on quoted prices in
active markets, where available. The Bank also transacts in commodity
derivative contracts which can be traded on an exchange or in OTC
markets. The fair value of derivative financial instruments is determined
as follows:
Derivative Financial Instruments
The fair value of exchange-traded derivative financial instruments is
based on quoted market prices. The fair value of OTC derivative finan-
cial instruments is estimated using well established valuation techniques,
such as discounted cash flow techniques, the Black-Scholes model,
and Monte Carlo simulation. The valuation models incorporate inputs
that are observable in the market or can be derived from observable
market data.
Prices derived by using models are recognized net of valuation
adjustments. The inputs used in the valuation models depend on the
type of derivative and the nature of the underlying instrument and are
specific to the instrument being valued. Inputs can include, but are not
limited to, interest rate yield curves, foreign exchange rates, dividend
yield projections, commodity spot and forward prices, recovery rates,
volatilities, spot prices, and correlation.
A credit risk valuation adjustment (CRVA) is recognized against the
model value of OTC derivatives to account for the uncertainty that
either counterparty in a derivative transaction may not be able to fulfill
its obligations under the transaction. In determining CRVA, the Bank
takes into account master netting agreements and collateral, and
considers the creditworthiness of the counterparty and the Bank itself,
in assessing potential future amounts owed to, or by the Bank.
In the case of defaulted counterparties, a specific provision is
established to recognize the estimated realizable value, net of collateral
held, based on market pricing in effect at the time the default is
recognized. In these instances, the estimated realizable value is
measured by discounting the expected future cash flows at an appro-
priate effective interest rate immediately prior to impairment, after
adjusting for the value of collateral. The fair value of non-trading
derivatives is determined on the same basis as for trading derivatives.
The fair value of a derivative is partly a function of collateralization.
The Bank uses the relevant overnight index swap (OIS) curve to
discount the cash flows for collateralized derivatives as most collateral
is posted in cash and can be funded at the overnight rate.
The fair value of residential mortgage-backed securities is primarily
based on broker quotes, third-party vendor prices, or other valuation
techniques, such as the use of option-adjusted spread (OAS) models
which include inputs such as prepayment rate assumptions related to
the underlying collateral. Observable inputs include, but are not limited
to, indexed yield curves, and bid-ask spreads. Other inputs may include
volatility assumptions derived using Monte Carlo simulations and take
into account factors such as counterparty credit quality and liquidity.
Other Debt Securities
The fair value of corporate and other debt securities, including debt
securities reclassified from trading to available-for-sale, is primarily
based on broker quotes, third-party vendor prices, or other valuation
techniques, such as discounted cash flow techniques. Market inputs
used in the valuation techniques or underlying third-party vendor
prices or broker quotes include benchmark and government yield
curves, credit spreads, and trade execution data.
Asset-backed securities are primarily fair valued using third-party
vendor prices. The third-party vendor employs a valuation model which
maximizes the use of observable inputs such as benchmark yield curves
and bid-ask spreads. The model also takes into account relevant data
about the underlying collateral, such as weighted average terms to
maturity and prepayment rate assumptions.
Equity Securities
The fair value of equity securities is based on quoted prices in active
markets, where available. Where quoted prices in active markets
are not readily available, such as for private equity securities, or where
there is a wide bid-offer spread, fair value is determined based on
quoted market prices for similar securities or through valuation tech-
niques, including discounted cash flow analysis, and multiples of
earnings before taxes, depreciation, and amortization, and other
relevant valuation techniques.
If there are trading restrictions on the equity security held, a valua-
tion adjustment is recognized against available prices to reflect the
nature of the restriction. However, restrictions that are not part of the
security held and represent a separate contractual arrangement that
has been entered into by the Bank and a third party do not impact the
fair value of the original instrument.
Retained Interests
Retained interests are classified as trading securities and are initially
recognized at relative fair value on the Bank’s Consolidated Balance
Sheet. Subsequently, the fair value of retained interests recognized
by the Bank is determined by estimating the present value of future
expected cash flows using management’s best estimates of key
assumptions including credit losses, prepayment rates, forward yield
curves and discount rates, that are commensurate with the risks
involved. Differences between the actual cash flows and the Bank’s
estimate of future cash flows are recognized in income. These
assumptions are subject to periodic review and may change due to
significant changes in the economic environment.
Loans
The estimated fair value of loans carried at amortized cost, other than
debt securities classified as loans, reflects changes in market price that
have occurred since the loans were originated or purchased. For fixed-
rate performing loans, estimated fair value is determined by discounting
the expected future cash flows related to these loans at current market
interest rates for loans with similar credit risks. For floating-rate
performing loans, changes in interest rates have minimal impact on fair
value since loans reprice to market frequently. On that basis, fair value
is assumed to approximate carrying value. The fair value of loans is not
adjusted for the value of any credit protection the Bank has purchased
to mitigate credit risk.