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.
techniques used to measure fair value, the significant inputs used in the valuation technique that are considered unobservable, and a range of values for those unobservable inputs. The range of values represents the highest and lowest inputs used in calculating the fair value.
Valuation techniques and inputs used in the fair value measurement of Level 3 assets and liabilities
The following table presents the Bank’s assets and liabilities recognized at fair value and classified as Level 3, together with the valuation
Valuation Techniques and Inputs Used in the Fair Value Measurement of Level 3 Assets and Liabilities
(millions of Canadian dollars, except as noted) As at
October 31, 2014
Significant
Fair value Fair value Valuation unobservable Lower Upper
assets liabilities technique inputs (Level 3) range range Unit
Government and government-
related securities $ 56 $ n/a1 Market comparable Bond price equivalent 100 101 points
Other debt securities 414 n/a Market comparable Bond price equivalent – 132 points Equity securities2 476 n/a Market comparable New issue price 100 100 % Discounted cash flow Discount rate 1 23 % EBITDA multiple Earnings multiple 5.3x 25x Market comparable Price equivalent 98 98 %
Prepayment and
Retained interests 48 n/a Discounted cash flow liquidation rates – 10 % Other financial assets designated
at fair value through profit or loss 5 n/a Market comparable Bond price equivalent 105 105 points Derivatives
Interest rate contracts – 81 Swaption model Currency specific volatility 8 188 %
Foreign exchange contracts 16 14 Option model Currency specific volatility 6 18 %
Credit contracts – – Discounted cash flow Credit spread 5 103 bps3
Equity contracts 1,033 1,537 Option model Price correlation 14 85 %
Quanto correlation (40) 17 %
Dividend yield – 11 %
Equity volatility 11 80 %
Commodity contracts 2 6 Option model Quanto correlation (45) (25) %
Swaption correlation 34 46 %
Trading deposits n/a 1,631 Option model Price correlation – 98 %
Quanto correlation (45) 18 %
Dividend yield – 11 %
Equity volatility 10 68 %
Swaption model Currency specific volatility 8 188 % Other financial liabilities designated
at fair value through profit or loss n/a 8 Option model Funding ratio 3 72 % Obligations related to securities
sold short n/a 34 Market comparable New issue price 100 100 % 1 Not applicable.
2 As at October 31, 2014, common shares exclude the fair value of
Federal Reserve Stock and Federal Home Loan Bank stock of $972 million (October 31, 2013 – $930 million) which are redeemable by the issuer at cost which approximates fair value. These securities cannot be traded in the market hence these securities have not been subjected to the sensitivity analysis.
spreads. For equity derivatives, the sensitivity was calculated by using reasonably possible alternative assumptions by shocking dividends by 5%, correlation by 10%, or the price of the underlying equity instru- ment by 10% and volatility from (13)% to 33%. For trading deposits, the sensitivity was calculated by varying unobservable inputs which may include volatility, credit spreads, and correlation.
The following table summarizes the potential effect of using reason- ably possible alternative assumptions for financial assets and financial liabilities held, as at October 31, that are classified in Level 3 of the fair value hierarchy. For interest rate derivatives, the Bank performed a sensitivity analysis on the unobservable implied volatility. For credit derivatives, sensitivity was calculated on unobservable credit spreads using assumptions derived from the underlying bond position credit
Sensitivity Analysis of Level 3 Financial Assets and Liabilities
(millions of Canadian dollars) As at
October 31, 2014
October 31, 2013
Impact to net assets
Impact to net assets
Decrease in Increase in Decrease in Increase in
fair value fair value fair value fair value
FINANCIAL ASSETS
Trading loans, securities, and other
Equity securities Common shares $ – $ – $ 1 $ 1 Preferred shares – – – – Retained interests 3 – 5 2 3 – 6 3 Derivatives
Interest rate contracts – – – –
Foreign exchange contracts – – – –
Equity contracts 21 22 30 35
21 22 30 35
Available-for-sale securities
Government and government related securities
Other OECD government guaranteed debt – – 1 1
Other debt securities
Corporate and other debt 2 – 2 –
Equity securities
Common shares 54 20 45 18
Preferred shares 8 8 7 7
Debt securities reclassified from trading 4 4 4 4
68 32 59 30