According to Basel II, where marking-to-market is not possible, banks may mark-to-model, where this can be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate. Supervisory authorities will consider the following in assessing whether a mark-to-model valuation is prudent:
• Senior management should be aware of the elements of the trading book which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.
• Market inputs should be sourced, to the extent possible, in line with market prices. The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.
• Where available, generally accepted valuation methodologies for particular products should be used as far as possible.
• Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation.
• There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations.
• Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output.
• The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs).
• Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.
The model should be created independent of the front office, and not by it. Therefore statement III does not represent an appropriate choice. Choice 'a' is the correct answer.
