2018 Registration document and annual fi nancial report - BNP PARIBAS210

4 CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEAR ENDED 31 DECEMBER 2018

4

Notes to the fi nancial statements

Structured derivatives classifi ed in Level 3 predominantly comprise structured derivatives of which hybrid products (FX/Interest Rates hybrids, Equity hybrids), credit correlation products, prepayment- sensitive products, some stock basket optional products and some interest rate optional instruments. The main exposures are described below, with insight into the related valuation techniques and on the source of uncertainty:

■ Structured interest rate options are classifi ed in Level 3 when they involve currencies where there is not suffi cient observation or when they include a quanto feature where the pay-off is measured with a forex forward fi xed rate (except for the main currencies). Long term structured derivatives are also classifi ed in Level 3.

■ Hybrid FX/Interest rate products essentially comprise a specific product family known as Power Reverse Dual Currency (PRDC). The valuation of PRDCs requires sophisticated modelling of joint behaviour of FX and interest rate, and is notably sensitive to the unobservable FX/interest rate correlations. PRDCs valuations are corroborated with recent trade data and consensus data.

■ Securitisation swaps mainly comprise fi xed rate swaps, cross currency or basis swaps whose notional is indexed to the prepayment behaviour of some underlying portfolio. The estimation of the maturity profi le of securitisation swaps is corroborated by statistical estimates using external historical data.

■ Forward volatility options are generally products whose pay-off is indexed to the future variability of a rate index such as volatility swaps. These products involve material model risk as it is diffi cult to infer forward volatility information from the market-traded instruments. The valuation adjustment framework is calibrated to the uncertainty inherent in the product, and to the range of uncertainty from the existing external consensus data.

■ Inflation derivatives classified in Level 3 mainly comprise swap products on infl ation indices that are not associated with a liquid indexed bond market, optional products on infl ation indices (such as caps and fl oors) and other forms of infl ation indices involving optionality on the infl ation indices or on the infl ation annual rate. Valuation techniques used for infl ation derivatives are predominantly standard market models. Proxy techniques are used for a few limited exposures. Although the valuations are corroborated through monthly consensus data, these products are classifi ed as Level 3 due to their lack of liquidity and some uncertainties inherent in the calibration.

■ The valuation of bespoke CDOs requires correlation of default events. This information is inferred from the active index tranche market through a proprietary projection technique and involves proprietary extrapolation and interpolation techniques. Multi-geography CDOs further require an additional correlation assumption. Finally, the bespoke CDO model also involves proprietary assumptions and parameters related to the dynamic of the recovery factor. CDO modelling, is calibrated on the observable index tranche markets,

and is regularly back-tested against consensus data on standardised pools. The uncertainty arises from the model risk associated with the projection and geography mixing technique, and the uncertainty of associated parameters, together with the recovery modelling.

■ N to Default baskets are other forms of credit correlation products, modelled through standard copula techniques. The main inputs required are the pair-wise correlations between the basket components which can be observed in the consensus and the transactions. Linear baskets are considered observable.

■ Equity and equity-hybrid correlation products are instruments whose pay-off is dependent on the joint behaviour of a basket of equities/ indices leading to a sensitivity of the fair value measurement to the correlation amongst the basket components. Hybrid versions of these instruments involve baskets that mix equity and non-equity underlyings such as commodity indices. Only a subset of the Equity/ index correlation matrix is regularly observable and traded, while most cross-asset correlations are not active. Therefore, classifi cation in Level 3 depends on the composition of the basket, the maturity, and the hybrid nature of the product. The correlation input is derived from a proprietary model combining historical estimators, and other adjustment factors, that are corroborated by reference to recent trades or external data. The correlation matrix is essentially available from consensus services, and when a correlation between two underlying instruments is not available, it might be obtained from extrapolation or proxy techniques.

These structured derivatives are subject to specifi c valuation adjustments to cover uncertainties linked to liquidity, parameters and model risk.

Valuation adjustments (CVA, DVA and FVA)

The valuation adjustment for counterparty credit risk (CVA), own-credit risk for derivatives (DVA) and the explicit funding valuation adjustment (FVA) are deemed to be unobservable components of the valuation framework and therefore classifi ed in Level 3. This does not impact, in general cases, the classifi cation of individual transactions into the fair value hierarchy. However, a specifi c process allows to identify individual deals for which the marginal contribution of these adjustments and related uncertainty is significant. Are particularly concerned some insuffi ciently collateralized vanilla interest rate instruments with very long residual maturity.

The below table provides the range of values of main unobservable inputs for the valuation of level 3 fi nancial instruments. The ranges displayed correspond to a variety of different underlying instruments and are meaningful only in the context of the valuation technique implemented by BNP Paribas. The weighted averages, where relevant and available, are based on fair values, nominal amounts or sensitivities.

The main unobservable parameters used for the valuation of debt issued in level 3 are equivalent to those of their economic hedge derivative. Information on these derivatives, displayed in the following table, is also applicable to these debts.