Basel II Extracts (26 June 2004)

688 ".....Basic Requirements for positions eligible to receive trading book capital treatment......Positions are actively monitored with reference to market information sources, (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles)"

690 "Prudent Valuation Guidance....This guidance is especially important for less liquid positions which, although they will NOT be excluded from the trading book solely on the grounds of lesser liquidity, raises supervisory concerns about prudent valuation."

Regular ‘fair value’ estimation will be a requirement under IAS39 even for those portfolios where you thought marking to market was never an issue.

One way or another, the ability to produce a ‘fair value’ of all portfolios is becoming a necessity rather than a luxury.

Whatever mechanism is adopted, it must be robust and consistent and must satisfy auditors, internal and external, as well as the regulatory authorities. With many instruments not being regularly traded or having publicly available pricing, any system which purports to calculate ‘fair market values’ must demonstrate a logical and consistent approach for deriving a ‘reasonable’ price.

• Illiquid Bonds – Many bonds are not publicly priced. Even when a price appears on a distributed information system such as Bloomberg or Reuters, it may be incorrect or inaccurate.

• Complex Instruments – products aimed at specific investment opportunities/requirements that may lose favour or simply not trade once placed with end-investors and, they may have been made more palatable to them, by having been ‘swapped’ through the use of derivatives into Libor-based instruments.

• Asset Swap Packages – An investor may purchase a bond with a derivative as a package yielding a Libor-plus-margin and then hold it in an investment portfolio to accrue the margin to the underlying funding cost. But it is wrong to assume that the current ‘fair value’ would yield the same margin today. It is a requirement that all elements of a "package" are marked-to-market. This is essential for assessing credit risk.

• Lack of comparative pricing – There are some issuers with very little paper in the market and issues cannot be priced using alternate and more liquid issues by the same issuer.

We look at your portfolio and put to one side those instruments where regular re-pricing is not a major issue, however, we would always advise a fall-back solution as:

• there is no guarantee that an issue which is liquid today will remain  liquid in the future

• there is no guarantee that all prices are accurate every day. Complex instruments will be examined and their price/yield relationship established,  as will any derivative hedges.

Instruments will then be classified in terms of several factors that affect their pricing, including:

• Credit Rating – whilst not all issuers of the same rating will trade at the same spread to the ‘risk free’ rate there is a general tendency to trade within small margins when the other factors affecting the price are the same.

• Currency of Issue – Issues in EUR, for example, do not always trade at the same spread to the ‘risk free’ rate as they do in USD or JPY or other currencies.

• Country of Issuer Residence – An American car manufacturer issuing in EUR, for example, will trade at different spreads to a European car manufacturer issuing in the same currency (given the same credit rating).

• Industrial Sector – The more the number of sectors the greater the accuracy. We currently provide 12 sectors and this will increase as demand and accuracy dictates.

• Time to maturity – There is a yield curve for spreads, just as there is for the underlying interest rates. Generally speaking the longer the time to maturity (or weighted maturity for non-bullet issues) the higher the spread.

• Degree of complexity – older issues which were aimed at particular opportunities in the market may no longer trade as their complexity is no longer understood or appreciated. We can either take your guidance on the weighting you want to attribute to reflect the degree of complexity (or lack of liquidity) or we can suggest our own factors.

By referencing the above variables for each instrument to a series of regularly produced spread matrices (the regularity to be determined by each client’s specific needs) a spread is derived. This spread is then added to the yield that a similar ‘risk free’ instrument (similar with respect to currency and maturity) currently yields to produce a total yield. Using this yield the theoretical price of the instrument can be determined.

• Charges will be based on the number of matrices supplied and the frequency of supply (daily, weekly, monthly).

• One-off charges apply to analysing the portfolios and any work required to implement the re-pricing routines. If your system is capable of re-pricing given yields (accurately reflecting the complexity of the instrument) then this cost will be minimal.

• Further charges apply if additional software (e.g. for complex option pricing routines) is required or additional market data (e.g. volatility surfaces and smiles).

Prices produced by the Front Office will not be independent and therefore not appropriate as a solution.

• Generic corporate curve solutions do not fully address the pricing of all illiquid instruments. They fail to address the problems of pricing bonds that do not fall into the "plain vanilla" category.

• Some suppliers offer specialised pricing services aimed at Credit Derivatives rather than bonds or similar assets. They rely on other contributors having similar positions on their books and re-supply aggregate data within this closed community. Needless to say, the very instruments that we are aiming to evaluate are likely to be unique and hence unlikely to be priced by consortia members.

• Other suppliers may supply valuations of bond positions but any derivative hedges will not necessarily be re-valued. Further work or alternative solutions will need to be implemented to price these derivatives. The value of the underlying bond is not necessarily off-set by the derivatives value!

• It is possible to build your own models to produce theoretical pricing but maintenance of the underlying matrices is very time-consuming and requires constant monitoring. To produce the pricing for one instrument it is still necessary to produce a whole series of matrices (one has to bear in mind that up- or –down-grading will necessitate production of additional matrices.