Valuation control and the daily risk report

Every number in this module, from the £1.94m VaR to the £9.01m stress loss, starts from the prices at which the desk marks its positions. If those marks are wrong, so is everything built on them, including the P&L the traders are paid on. This lesson checks the marks, makes them prudent, and then puts the whole module onto the one page that the desk, market risk and the CRO read every morning.

Independent price verification

Traders markThe price at which the front office values a position at the end of the day. their positions at the close. They know the market best, but they also benefit from high marks, so the marks are checked by someone who does not: product controlThe team, usually in Finance, that owns the official P&L and runs independent price verification., usually part of Finance. This is independent price verificationIndependent price verification: checking the front office's marks, or the inputs to its models, against sources the traders do not control. (IPV): compare each mark, or each model input, with exchange prices, dealer quotes, broker screens or a consensus pricing service. A gap within the toleranceThe largest gap between the front office's mark and the independent level that is accepted without adjustment. is accepted; a larger gap is adjusted in the official P&L and investigated.

Two positions fail. The puts are marked at 16.0 vol points against a consensus of 15.4: with a vega of £124k per point they are overvalued by £74,455. The corporate bonds are marked at a 120bp spread; three dealers quote 122, 126, 131bp, so the independent level is 126bp and the bonds are overvalued by £205,820. Product control books an adjustment of −£280,274 and asks the desk why its marks drifted. The gilt, swap and FX gaps are inside tolerance and left alone.

How observable is the price?

Accounting sorts fair values by the inputs behind them: the fair value hierarchyIFRS 13's three levels for fair value inputs: Level 1 quoted prices for identical assets in active markets, Level 2 other observable inputs, Level 3 unobservable inputs. of IFRS 13. The less observable the input, the harder the IPV and the more disclosure and caution are needed.

Prudent valuation

Fair value is an exit price in an orderly sale. Bank regulators want more caution for capital: under the EU's prudent valuation standard, which the UK carried into its own rules after Brexit, a bank values each position at a level it is 90% confident it could exit at or better. The difference between fair value and this prudent valueA value at which the bank is 90% confident it could exit the position, under the EU's prudent valuation standard. It is at or below fair value for assets. is a set of additional valuation adjustmentsAdditional valuation adjustment: the gap between fair value and prudent value for one source of valuation uncertainty, deducted from CET1 capital. (AVAs), deducted from common equity tier 1 capital. The standard lists nine: market price uncertainty, close-out costs, model risk, unearned credit spreads, investing and funding costs, concentrated positions, future administrative costs, early termination and operational risk. For the desk, four matter:

Smaller banks (fair-valued assets and liabilities below €15 billion) may instead use a simplified approach: 0.1% of the absolute fair values. On the desk's £210m of positions that would be only £209,746, under a quarter of the estimate above, because the concentrated bond holding drives most of the uncertainty. The real calculation has more detail, including how individual AVAs are aggregated; it belongs to M4.7: Accounting for risk.

The daily risk report

L2.4.07: Risk reporting set out what makes a good risk report. For a trading desk it is the daily risk packThe report the desk, market risk and senior management read every morning: P&L, risk measures, limits, backtesting, stress tests and valuation.: one page, the same layout every day, ready before the market opens. Here is the desk's, built entirely from this module's figures:

The value of an IPV gap. For a position whose value depends on an input $x$ with sensitivity $\partial V/\partial x$, marked at $x_{\text{FO}}$ and verified at $x_{\text{IPV}}$:

Market price uncertainty at 90%. With $n$ independent quotes of mean $\bar s$ and sample standard deviation $s_q$, one simple estimate of the prudent spread, assuming normal quote errors, is

Banks use richer methods (the range of quotes, consensus data, expert judgement), but the logic is the same: find the price at the 90% point of the plausible range and measure how far it sits from fair value.

Move the independent level until the corporate bonds pass, then tighten the tolerance until the gilt fails. Notice how small input gaps turn into large sums for positions with big sensitivities.

The EU Capital Requirements Regulation (Article 105) requires banks to value trading positions prudently, with independent price verification, and the European Banking Authority's technical standard on prudent valuation (Commission Delegated Regulation (EU) 2016/101) sets out the nine AVAs, the 90% confidence level and the simplified approach below €15 billion. In the UK the PRA moved both into its Rulebook (the Trading Book (CRR) Part) from 1 January 2022, keeping the simplified and core approaches. Fair value and its hierarchy come from IFRS 13. Both are covered in M4.7: Accounting for risk. The Basel Committee's principles for risk data aggregation and risk reporting (BCBS 239, January 2013) set the standard for reports like the daily pack; they are in M4.9: Supervision, stress testing and disclosure.

• Independent price verification checks the desk's marks against sources the traders do not control; gaps beyond tolerance are adjusted.
• An input gap times the position's sensitivity gives the value gap: 6bp × £34,303 per bp is £205,820 on the corporate bonds.
• IFRS 13's hierarchy sorts fair values by how observable their inputs are; Level 3 needs the most control.
• Prudent value is the 90%-confidence exit level; the gap to fair value is a set of AVAs deducted from CET1.
• The daily risk pack brings P&L, VaR, ES, limits, backtesting, stress and valuation onto one page that never changes shape.

Mark

The price at which the front office values a position at the end of the day.

Independent price verification (IPV)

Independent price verification: checking the front office's marks, or the inputs to its models, against sources the traders do not control.

Product control

The team, usually in Finance, that owns the official P&L and runs independent price verification.

Tolerance

The largest gap between the front office's mark and the independent level that is accepted without adjustment.

Fair value hierarchy

IFRS 13's three levels for fair value inputs: Level 1 quoted prices for identical assets in active markets, Level 2 other observable inputs, Level 3 unobservable inputs.

Prudent value

A value at which the bank is 90% confident it could exit the position, under the EU's prudent valuation standard. It is at or below fair value for assets.

Additional valuation adjustment (AVA)

Additional valuation adjustment: the gap between fair value and prudent value for one source of valuation uncertainty, deducted from CET1 capital.

Daily risk pack

The report the desk, market risk and senior management read every morning: P&L, risk measures, limits, backtesting, stress tests and valuation.