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286 NEDBANK GROUP Limited INTEGRATED REPORT 20106 Fair-value measurement ... continued6.1 Valuation of financial instruments ... continuedValuation methodologies ... continuedIf a published price quotation in an active market does not exist for a financial instrument in its entirety, but active markets exist forits component parts, fair value is determined on the basis of the relevant market prices for the various component parts.If a rate (rather than a price) is quoted in an active market, the group uses that market-quoted rate as an input into a valuationtechnique to determine fair value. If the market quoted rate does not include credit risk or other factors that market participants wouldinclude in valuing the instrument, the group adjusts for these factors.Valuation techniques applied by the group would generally be classified as level 2 or level 3 in terms of the fair-value hierarchy prescribedby IFRS 7 Financial Instruments: Disclosure. The determination of whether an instrument is classified as level 2 or level 3 is dependent onthe degree of observable inputs versus unobservable inputs used in determining the fair value.Observable marketsQuoted market prices in active markets are the best evidence of fair value and are used as the basis of measurement, if available.A determination of what constitutes ‘observable market data’ will necessitate significant judgement. It is the group’s belief that ‘observablemarket data’ comprises, in the following hierarchical order:• prices or quotes from exchange or listed markets in which there are sufficient liquidity and activity;• proxy observable market data that is proven to be highly correlated and has a logical, economic relationship with the instrument thatis being valued; and• other direct and indirect market inputs that are observable in the marketplace.Data is considered by the group to be ‘observable’ if the data is:• verifiable;• readily available;• regularly distributed;• from multiple independent sources;• transparent; and• not proprietary.Data is considered by the group to be ‘market-based’ if the data is:• reliable;• based on consensus within reasonable narrow, observable ranges;• provided by sources that are actively involved in the relevant market; and• supported by actual market transactions.It is not intended to imply that all of the above characteristics must be present to conclude that the evidence qualifies as observablemarket data. Judgement is applied based on the strength and quality of the available evidence.Inputs to valuation techniquesA suitable valuation technique for estimating the fair value of a particular financial instrument would incorporate observable market dataabout the market conditions and other factors that are likely to affect the instrument’s fair value. The principal inputs to these valuationtechniques include the following:• Discount rate: Where discounted-cashflow techniques are used, estimated future cashflows are based on management’s best estimatesand the discount rate used is a market rate at the reporting date for an instrument with similar terms and conditions.
287Reports andcertificationsConsolidatedannual financialstatementsShareholdermeeting mattersDefinitions andabbreviationsInstrumentcodesContactdetailsnotes to the financial statements for the year ended 31 December 2010• The time value of money: The business may use well-accepted and readily observable general interest rates, such as the JohannesburgInterbank Agreed Rate (South Africa), London Interbank Offered Rate (United Kingdom) or an appropriate swap rate, as the benchmarkrate to derive the present value of a future cashflow.• Credit risk: Credit risk is the risk of loss associated with a counterparty’s failure or inability to fulfil its contractual obligations. Thevaluation of the relevant financial instrument takes into account the effect of credit risk on fair value by including an appropriateadjustment for the risk taken.• Foreign currency exchange prices: Active currency exchange markets exist for most major currencies, and prices are quoted daily onvarious trading platforms and in financial publications.• Commodity prices: Observable market prices are available for those commodities that are actively traded on exchanges in South Africa,London, New York and Chicago, as well as on other commercial exchanges.• Equity prices: Prices (and indices of prices) of traded equity instruments are readily observable on JSE Limited or any other recognisedinternational exchange. Present value techniques may be used to estimate the current market price of equity instruments for whichthere are no observable prices.• Volatility: Measures of the volatility of actively traded items can be reasonably estimated by the implied volatility in current marketprices. The shape and skew of the volatility curve is derived from a combination of observed trades and doubles in the market. In theabsence of an active market, a methodology to derive these volatilities from observable market data will be developed and utilised.• Recovery rates/Loss given default (LGD): These are used as an input to valuation models as an indicator of the severity of losses ondefault. Recovery rates are primarily sourced from market data providers or inferred from observable credit spreads.• Prepayment risk and surrender risk: Expected repayment patterns for financial assets and expected surrender patterns for financialliabilities can be estimated on the basis of historical data.• Servicing costs: If the cost of servicing a financial asset or financial liability is significant and other market participants would facecomparable costs, the issuer would consider them in determining the fair value of that financial asset or financial liability.• Dividends: Consistent consensus dividend forecasts adjusted for internal investment analysts’ projections can be applied to each share.Forecasts are usually available for the current year plus one additional year. Thereafter, a constant growth rate would be applied to thespecific dates into the future for each individual share.• Inception profit (day-one gain or loss): The best evidence of the fair value of a financial instrument at initial recognition is thetransaction price (ie the fair value of the consideration given or received), unless the fair value of that instrument is evidenced bycomparison with other observable current market transactions in the same instrument (ie without modification or repackaging) orbased on a valuation technique, the variables of which include data from observable markets only.Valuation adjustmentsTo determine a reliable fair value, where appropriate, the group applies certain valuation adjustments to the pricing information derivedfrom the above sources. In making appropriate adjustments, the group considers certain adjustments to the modelled price that marketparticipants would make when pricing that instrument. Factors that would be considered include the following:• Own credit on financial liabilities: The carrying amount of financial liabilities held at fair value is adjusted to reflect the effect ofchanges in the group’s own credit spreads. As a result, the carrying value of issued bonds and subordinated-debt instruments thathave been designated as at fair value through profit or loss is adjusted by reference to the movement in the appropriate spreads. Theresulting gain or loss is recognised in profit and loss in the statement of other comprehensive income.• Counterparty credit spreads: Adjustments are made to market prices when the creditworthiness of the counterparty differs from thatof the assumed counterparty in the market price (or parameter).Valuation techniques by instrument• Other short-term securities and government and other securitiesThe fair value of these instruments is based on quoted market prices from an exchange dealer, broker, industry group or pricing service,when available. When they are unavailable, the fair value is determined by reference to quoted market prices for similar instruments,adjusted as appropriate for the specific circumstances of the instruments.
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