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The following is a discussion of the significant unobservable inputs or valuation technique used in determining the fair
value of securities and derivatives classified as Level 3.
Net Asset Value
We hold certain unlisted equity securities whose fair value is derived based on the financial statements published by
the investee. These securities do not trade on an active market and the valuations derived are dependent on the
availability of timely financial reporting of the investee. Net asset value is an unobservable input in the determination of fair
value of equity securities.
Offered Quotes
In circumstances where our valuation model price is overridden because it implies a value that is not consistent with
current market conditions, we will solicit bids from a limited number of brokers. We also receive unadjusted prices from
brokers for our mortgage and asset-backed securities. These quotes are non-binding but are reflective of valuation best
estimates at that particular point in time. Offered quotes are an unobservable input in the determination of fair value of
mortgage- and asset-backed securities, certain banks/financial institutions, certain other corporate, and equity securities
investments.
Interest Rates, CDS Spreads, Foreign Exchange Rates
The significant drivers of the valuation of the interest and foreign exchange swaps are interest rates, foreign exchange
rates and CDS spreads. Our swaps have long maturities that increase the sensitivity of the swaps to interest rate
fluctuations. Since most of our yen-denominated cross currency swaps are in a net liability position, an increase in interest
rates will decrease the liabilities and increase the value of the swap.
Foreign exchange swaps also have a lump-sum final settlement of foreign exchange principal receivables at the
termination of the swap. An increase in yen interest rates will decrease the value of the final settlement foreign exchange
receivables and decrease the value of the swap, and an increase in U.S. dollar interest rates increase the swap value.
A similar sensitivity pattern is observed for the foreign exchange rates. When the spot U.S. dollar/Japanese yen (USD/
JPY) foreign exchange rate decreases and the swap is receiving a final exchange payment in JPY, the swap value will
increase due to the appreciation of the JPY. Most of our swaps are designed to receive payments in JPY at the
termination and will thus be impacted by the USD/JPY foreign exchange rate in this way. In cases where there is no final
foreign exchange receivable in JPY and we are paying JPY as interest payments and receiving USD, a decrease in the
foreign exchange rate will lead to a decrease in the swap value.
The extinguisher feature in most of our swaps results in a cessation of cash flows and no further payments between
the parties to the swap in the event of a default on the referenced or underlying collateral. To price this feature, we apply
the survival probability of the referenced entity to the projected cash flows. The survival probability uses the CDS spreads
and recovery rates to adjust the present value of the cash flows. For extinguisher swaps with positive values, an increase
in CDS spreads decreases the likelihood of receiving the final exchange payments and reduces the value of the swap.
Due to the long duration of these swaps and the need to extrapolate from short-term observable data to derive and
measure long-term inputs, certain inputs, assumptions and judgments are required to value future cash flows that cannot
be corroborated by current inputs or current observable market data.
Interest rates, CDS spreads, and foreign exchange rates are unobservable inputs in the determination of fair value of
foreign currency swaps.
Base Correlations, CDS Spreads, Recovery Rates
Our remaining CDO is a tranche on a basket of single-name credit default swaps. The risk in this synthetic CDO
comes from the single-name CDS risk and the correlations between the single names. The valuation of synthetic CDOs is
dependent on the calibration of market prices for interest rates, single name CDS default probabilities and base
correlation using financial modeling tools. Since there is limited or no observable data available for this tranche, the base
correlations must be obtained from commonly traded market tranches such as the CDX and iTraxx indices. From the
historical prices of these indices, base correlations can be obtained to develop a pricing curve of CDOs with different
seniorities. Since the reference entities of the market indices do not match those in the portfolio underlying the synthetic
CDO to be valued, several processing steps are taken to map the CDO in our portfolio to the indices. With the base
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