TD Bank 2014 Annual Report Download - page 152

TD BANK GROUP ANNUAL REPORT 2014 FINANCIAL RESULTS150
Implied Volatility
Implied volatility is the value of the volatility of the underlying instrument
which, when input in an option pricing model, such as Black-Scholes,
will return a theoretical value equal to the current market price of the
option. Implied volatility is a forward-looking and subjective measure,
and differs from historical volatility because the latter is calculated
from known past returns of a security.
Funding ratio
The funding ratio is a significant unobservable input required to value
mortgage commitments issued by the Bank. The funding ratio represents
an estimate of percentage of commitments that are ultimately funded
by the Bank. The funding ratio is based on a number of factors such
as observed historical funding percentages within the various lending
channels and the future economic outlook, considering factors including,
but not limited to, competitive pricing and fixed/variable mortgage rate
gap. An increase/(decrease) in funding ratio will increase/(decrease)
the value of the lending commitment in relationship to prevailing
interest rates.
Earnings Multiple, Discount Rate and Liquidity Discount
Earnings multiple, discount rate and liquidity discount are significant
inputs used when valuing certain equity securities. Earnings multiples
are selected based on comparable entities and a higher multiple will
result in a higher fair value. Discount rates are applied to cash flow
forecasts to reflect time value of money and the risks associated with
the cash flows. A higher discount rate will result in a lower fair value.
Liquidity discounts may be applied as a result of the difference in
liquidity between the comparable entity and the equity securities
being valued.
Currency Specific Swap Curve
The fair value of foreign exchange contracts is determined using inputs
such as foreign exchange spot rates and swap curves. Generally swap
curves are observable, but there may be certain durations, or currency
specific foreign exchange spot and currency specific swap curves that
are not observable.
Dividend Yield
Dividend yield is a key input for valuing equity contracts and is generally
expressed as a percentage of the current price of the stock. Dividend
yields can be derived from the repo or forward price of the actual
stock being fair valued. Spot dividend yields can also be obtained from
pricing sources, if it can be demonstrated that spot yields are a good
indication of future dividends.
VALUATION OF ASSETS AND LIABILITIES CLASSIFIED
AS LEVEL 3
Significant unobservable inputs in Level 3 positions
The following section discusses the significant unobservable inputs
for Level 3 positions and assesses the potential effect that a change
in each observable input may have on the fair value measurement.
Price Equivalent
Certain financial instruments, mainly debt and equity securities, are
valued using price equivalents when market prices are not available,
with fair value measured by comparison with observable pricing data
from instruments with similar characteristics. The price equivalent is
expressed in points, and represents a percentage of the par amount.
There may be wide ranges depending on the liquidity of the securities.
Prices at the lower end of the range are generally a result of securities
that are written down.
Credit Spread
Credit spread is a significant input used in the valuation of many
derivatives. It is the primary reflection of the credit worthiness of a
counterparty and represents the premium or yield return above the
benchmark reference that a bond holder would require in order to
allow for the credit quality difference between the entity and the
reference benchmark. An increase/(decrease) in credit spread will
(decrease)/increase the value of financial instrument. Credit spread
may be negative where the counterparty is more credit worthy than
the benchmark against which the spread is calculated. A wider
credit spread represents decreasing credit worthiness.
Prepayment Rate and Liquidation Rate
Expected future prepayment and liquidation rates are significant inputs
for retained interests and represent the amount of unscheduled
principal repayment. The prepayment rate and liquidation rate will be
obtained from prepayment forecasts which are based on a number
of factors such as historical prepayment rates for similar pool loans
and the future economic outlook, considering factors including, but
not limited to, future interest rates.
Correlation
The movements of inputs are not necessarily independent from other
inputs. Such relationships, where material to the fair value of a given
instrument, are captured via correlation inputs into the pricing models.
The Bank includes correlation between the asset class, as well as across
asset classes. For example, price correlation is the relationship between
prices of equity securities in equity basket derivatives, and quanto
correlation is the relationship between instruments which settle in one
currency and the underlying securities which are denominated in
another currency.