Quoted market prices in active markets are the most reliable measure of fair value . However, quoted market prices for certain instruments, investments and activities, such as non-exchange traded contracts and venture capital companies and nonmarketable equity securities may not be available.
When quoted market prices are not available, derivatives and securities values are determined based upon discounted cash flow analysis, comparison to similar observable market transactions, or the use of financial models. Discounted cash flow analysis is dependent upon estimated future cash flows and the discount rate used. Valuation using pricing models is dependent upon time value, yield curve, volatility factors, prepayment speeds, default rates, loss severity, current market prices and transaction prices for underlying financial instruments. Pricing adjustments to model our portfolio valuations consider liquidity, credit exposure, concentration risks, hedging strategies, quality of model inputs, and other factors.
Where valuation of financial instruments is subjective due to the lack of observable market prices or inputs, management must apply judgment to make estimates and certain assumptions. For example, if prices or inputs to financial models are used for similar financial instruments, judgment is applied to make appropriate adjustments for differences in credit risk , liquidity or other factors.
Since the fair value determined might differ from actual net realizable values, the estimates are considered critical accounting estimates for our Corporate Banking & Securities Corporate Division, which trades certain over-the-counter derivatives, some of which have long terms or complex structures that are valued using financial models. Fair value estimates are also critical for our Corporate Investments Group Division, which holds investments that are not actively traded.
To maximize the accuracy of our valuations, we have established internal controls over the valuation process, which include independent price verification, testing and approval of valuation models, review and analysis of daily profit and loss, validation of valuation through close out profit and loss, and VaR backtesting. We perform price testing of model input parameters and prices of cash instruments, confirming that valuations have been performed using approved models and determining the appropriateness of valuations. We also test and approve pricing models.