Citigroup Inc.

Trading account assets and liabilities—derivativesExchange-traded derivatives are generally fair valued using quoted market(i.e., exchange) prices and so are classified as Level 1 of the fair valuehierarchy.The majority of derivatives entered into by the Company are executedover the counter and so are valued using internal valuation techniques as noquoted market prices exist for such instruments. The valuation techniquesand inputs depend on the type of derivative and the nature of the underlyinginstrument. The principal techniques used to value these instruments arediscounted cash flows, Black-Scholes and Monte Carlo simulation. The fairvalues of derivative contracts reflect cash the Company has paid or received(for example, option premiums paid and received).The key inputs depend upon the type of derivative and the nature ofthe underlying instrument and include interest rate yield curves, foreignexchangerates, the spot price of the underlying volatility and correlation.The item is placed in either Level 2 or Level 3 depending on the observabilityof the significant inputs to the model. Correlation and items with longertenors are generally less observable.Subprime-related direct exposures in CDOsThe valuation of high-grade and mezzanine asset-backed security (ABS)CDO positions uses trader prices based on the underlying assets of each highgradeand mezzanine ABS CDO. The high-grade and mezzanine positionsare now largely hedged through the ABX and bond short positions, which aretrader priced. This results in closer symmetry in the way these long and shortpositions are valued by the Company. Citigroup intends to use trader marksto value this portion of the portfolio going forward so long as it remainslargely hedged.For most of the lending and structuring direct subprime exposures,fair value is determined utilizing observable transactions where available,other market data for similar assets in markets that are not active and otherinternal valuation techniques.InvestmentsThe investments category includes available-for-sale debt and marketableequity securities, whose fair value is determined using the same proceduresdescribed for trading securities above or, in some cases, using vendor pricesas the primary source.Also included in investments are nonpublic investments in private equityand real estate entities held by the S&B business. Determining the fairvalue of nonpublic securities involves a significant degree of managementresources and judgment as no quoted prices exist and such securities aregenerally very thinly traded. In addition, there may be transfer restrictionson private equity securities. The Company uses an established process fordetermining the fair value of such securities, using commonly acceptedvaluation techniques, including the use of earnings multiples based oncomparable public securities, industry-specific non-earnings-based multiplesand discounted cash flow models. In determining the fair value of nonpublicsecurities, the Company also considers events such as a proposed sale ofthe investee company, initial public offerings, equity issuances or otherobservable transactions. As discussed in Note 15, the Company uses NAV tovalue certain of these entities.Private equity securities are generally classified as Level 3 of the fair valuehierarchy.Short-term borrowings and long-term debtWhere fair value accounting has been elected, the fair values ofnon‐structured liabilities are determined by discounting expected cashflows using the appropriate discount rate for the applicable maturity. Suchinstruments are generally classified as Level 2 of the fair value hierarchy asall inputs are readily observable.The Company determines the fair values of structured liabilities (whereperformance is linked to structured interest rates, inflation or currency risks)and hybrid financial instruments (performance linked to risks other thaninterest rates, inflation or currency risks) using the appropriate derivativevaluation methodology (described above) given the nature of the embeddedrisk profile. Such instruments are classified as Level 2 or Level 3 dependingon the observability of significant inputs to the model.Market valuation adjustmentsLiquidity adjustments are applied to items in Level 2 and Level 3 of thefair value hierarchy to ensure that the fair value reflects the price at whichthe entire position could be liquidated in an orderly manner. The liquidityreserve is based on the bid-offer spread for an instrument, adjusted to takeinto account the size of the position consistent with what Citi believes amarket participant would consider.Counterparty credit-risk adjustments are applied to derivatives, suchas over-the-counter derivatives, where the base valuation uses marketparameters based on the LIBOR interest rate curves. Not all counterpartieshave the same credit risk as that implied by the relevant LIBOR curve, so it isnecessary to consider the market view of the credit risk of a counterparty inorder to estimate the fair value of such an item.261