8. Fair value of financial instruments

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is therefore a market-based measurement and not specific to each entity.

If there is no market price for a given financial asset or liability, its fair value is estimated on the basis of the price established in recent transactions involving similar instruments or, in the absence thereof, by using mathematical measurement models that are sufficiently tried and trusted by the international financial community. The estimates used in such models take into consideration the specific features of the asset or liability to be measured and, in particular, the various types of risk associated with the asset or liability. However, the limitations inherent in the measurement models and possible inaccuracies in the assumptions and parameters required by these models may mean that the estimated fair value of an asset or liability does not exactly match the price for which the asset or liability could be exchanged or settled on the date of its measurement.

The fair value of the financial derivatives included in the held-for-trading portfolios is based on daily quoted price if there is an active market for these financial derivatives. If for any reason their quoted price is not available on a given date, these financial derivatives are measured using methods similar to those used in over-the-counter (OTC) markets.

The fair value of OTC derivatives (“present value” or “theoretical price”) is equal to the sum of future cash flows arising from the instrument, discounted at the measurement date; these derivatives are valued using methods recognized by international financial markets: the “net present value” (NPV) method, option price calculation models, etc.

Below is a comparison of the carrying amount of the Group’s financial instruments in the accompanying consolidated balance sheets and their respective fair values. Not all assets and liabilities are registered at fair value. The following items are registered at their amortized cost: “Cash and balances with central banks”, “Loans and receivables”, “Held to maturity investments” and financial liabilities at amortized cost:

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Fair Value and Carrying Amount		Millions of Euros
	Notes	2013		2012		2011
		Carrying Amount	Fair Value	Carrying Amount	Fair Value	Carrying Amount	Fair Value
ASSETS-
Cash and balances with central banks	9	34,903	34,903	35,494	35,494	29,841	29,841
Financial assets held for trading	10	72,112	72,112	79,829	79,829	70,471	70,471
Other financial assets designated at fair value through profit or loss	11	2,413	2,413	2,530	2,530	2,773	2,773
Available-for-sale financial assets	12	77,774	77,774	67,500	67,500	54,641	54,641
Loans and receivables	13	350,945	364,120	371,347	391,594	369,916	377,722
Held-to-maturity investments	14	-	-	10,162	9,805	10,955	10,190
Fair value changes of the hedges items in portfolio hedges of interest rate risk	15	98	98	226	226	146	146
Hedging derivatives	15	2,530	2,530	4,894	4,894	4,538	4,538
LIABILITIES-
Financial assets held for trading	10	45,648	45,648	55,834	55,834	51,178	51,178
Other financial liabilities designated at fair value through profit or loss	11	2,467	2,467	2,216	2,216	1,621	1,621
Financial liabilities at amortized cost	23	464,141	466,240	490,605	488,163	465,717	459,698
Fair value changes of the hedged items in portfolio hedges of interest rate risk.	15	-	-	-	-	-	-
Hedging derivatives	15	1,792	1,792	2,968	2,968	2,709	2,709

For financial instruments whose carrying amount is equivalent to their fair value, the measurement processes used are set forth below:

• Level 1: Measurement using market observable quoted prices for the financial instrument in question, secured from independent sources and referred to active markets. This level includes listed debt securities, listed equity instruments, some derivatives and mutual funds.
• Level 2: Measurement that applies techniques using inputs drawn from observable market data.
• Level 3: Measurement using techniques where some of the inputs are not taken from market observable data. As of December 31, 2013, the affected instruments accounted for approximately 0.16% of financial assets and 0.01% of the Group’s financial liabilities. Model selection and validation is undertaken by control areas outside the market units.

8.1 Fair value of certain financial instruments registered at fair value using valuation criteria

The following table shows the main financial instruments carried at fair value in the accompanying consolidated balance sheets, broken down by the measurement technique used to determine their fair value:

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Fair Value by Levels		Millions of Euros
	Notes	2013			2012			2011
		Level 1	Level 2	Level 3	Level 1	Level 2	Level 3	Level 1	Level 2	Level 3
ASSETS-
Financial assets held for trading	10	34,394	37,427	290	30,890	48,530	412	22,952	46,819	700
Loans and advances to customers		-	106	-	244	-	-	-	-	-
Debt securities		28,573	852	176	27,007	718	295	19,703	792	450
Equity instruments		4,596	111	58	2,705	140	70	2,027	97	68
Trading derivatives		1,225	36,358	56	934	47,672	47	1,221	45,930	182
Other financial assets designated at fair value through profit or loss	11	2,352	61	-	2,468	62	-	2,358	415	-
Loans and advances to credit institutions		-	-	-	-	-	-	-	-	-
Debt securities		603	61	-	691	62	-	647	61	-
Equity instruments		1,749	-	-	1,777	-	-	1,711	354	-
Available-for-sale financial assets	12	57,957	18,710	591	47,692	18,545	753	38,193	14,844	1,064
Debt securities		52,726	18,515	566	44,496	18,353	699	34,195	14,620	602
Equity instruments		5,231	195	25	3,196	192	54	3,998	224	462
Hedging derivatives	15	52	2,478	-	111	4,783	-	289	4,249	-
LIABILITIES-
Financial liabilities held for trading	10	8,459	37,172	17	7,371	48,425	38	5,813	45,342	23
Trading derivatives		931	37,172	17	791	48,425	38	1,202	45,342	23
Short positions		7,528	-	-	6,580	-	-	4,611	-	-
Other financial liabilities designated at fair value through profit or loss	11	-	2,467	-	-	2,216	-	-	1,621	-
Hedging derivatives	15	-	1,757	35	-	2,951	17	-	2,709	-

The heading “Available-for-sale financial assets” in the accompanying consolidated balance sheets as of December 31, 2013, 2012 and 2011 additionally includes €516, €510 million and €541 million, respectively, accounted for at cost, as indicated in the section of this Note entitled “Financial instruments at cost”.

Process for determining the fair value established in the entity

To ensure that trading portfolio assets are properly valued, BBVA has established, at a geographic level, a structure of New Product Committees responsible for validating and approving new products or types of assets and liabilities before being contracted. The members of these Committees, responsible for valuation, are independent from the business.

These areas are required to ensure, prior to the approval stage, the existence of not only technical and human resources, but also adequate informational sources to measure these assets and liabilities, in accordance with the rules established by the Global Valuation Area and using models that have been validated and approved by the Department of Technology and Methodologies that reports to GRM (see Note 7).

Additionally, for assets that show significant uncertainty in inputs or model parameters used for assessment, criteria is established to measure said uncertainty and activity limits are set based on these.

Finally, these measurements are compared, as much as possible, against other sources such as the measurements obtained by the business teams or those obtained by other market participants.

The following table sets forth the main measurement techniques, hypothesis and inputs used in the estimation of fair value of the financial instruments classified under Levels 2 and 3, based on the type of financial asset and liability and the corresponding balances as of December 31, 2013:

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Financial Instruments Level 2	Fair Value (Millons of euros)	Main Measurement techniques	Main inputs used
Loans and advances to customers		Present value Method Determining the present-value of financial instruments as the current value of future cash flows (discounted at market interest rates), taking into account: – the estimate of prepayment rates; – the issuer credit risk; and – current market interest rates. – Net Asset Value (NAV) published recurrently, but not more frequently than every quarter	– Risk premiums. – Observable market interest rates
Available-for-sale financial assets	106
Debt securities
Trading portfolio	852
Other financial assets at fair value through profit and loss	61
Available-for-sale financial assets	18,515
Equity Instruments
Trading portfolio	111
Available-for-sale financial assets	195
Other financial liabilities
Other financial liabilities designated at fair value through profit or loss	2,467
Trading derivatives		• Commodities: Discounted cash flows and moment adjustment • Credit products: Default model, Gaussian copula and Black Derman Toy • Exchange rate products: Discounted cash flows and Black Scholes • Fixed income products: Discounted cash flows • Equity instruments: Local-Vol, Black and Discounted cash flows • Interest rate products: – Interest rate swaps, Call money Swaps y FRA: Discounted cash flows – Caps/Floors , bond options y Swaptions: Black – Interest rate options: Hull-White y SABR	Observable market data
Trading asset portfolio	36,358
Trading liability portfolio	37,172
Hedging derivatives
Asset	2,478
Liability	1,757

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Financial Instruments Level 3	Fair Value (Millons of euros)	Main Measurement techniques	Main inputs used
Debt securities		• CDO: Time Default Model (Probability of default measure)	– Correlation of defaults extrapolated from several index tranches (ITRA00 nad CDX) with the underlying portfolio of our CDOs
Trading portfolio	176
Available-for-sale financial assets	566
Equity Instruments		Present-value method (Discounted future cash flows)	– Prepayment Rates – Default Correlation – Credit Spread – NAV supplied by the fund administrator or issuer of the securities
Trading portfolio	58
Available-for-sale financial assets	25
Trading derivatives		• Credit Option: Gaussian Copula and Libor Market Model • Equity OTC Options : Heston • Interest rate options: Libor Market Model	– Non directly observable market data – Historical Series
Trading asset portfolio	57
Trading liability portfolio	17
Hedging derivatives
Liability	35

Adjustments to the valuation for risk of default

The credit valuation adjustments (“CVA”) and debit valuation adjustments (“DVA”) are a part of derivative valuations, both assets and liabilities, to reflect the impact in the fair value of the credit risk of the counterparty and its own, respectively.

These adjustments are calculated by estimating Exposure At Default, Probability of Default and Loss Given Default, for all derivative products on any instrument at the legal entity level (all counterparties under a same ISDA / CMOF) in which BBVA has exposure.

As a general rule, the calculation of CVA is done through simulations of market and credit variables to calculate the expected positive exposure, given the Exposure at Default and multiplying the result by the Loss Given Default of the counterparty. Consequently, the DVA is calculated as the result of the expected negative exposure given the Exposure at Default and multiplying the result by the Loss Given Default of the counterparty. Both calculations are performed throughout the entire period of potential exposure.

The information needed to calculate the exposure at default and the loss given default come from the credit markets (Credit Default Swaps or iTraxx Indexes), save for cases where an internal rating is available. For those cases where the information is not available, BBVA implements a mapping process based on the sector, rating and geography to assign probabilities of both probability of default and loss given default, calibrated directly to market or with an adjustment market factor for the probability of default and the historical expected loss.

The impact recorded under "Net gains (losses) on financial asset and liabilities" in the consolidated income statement for the year ended December 31, 2013 corresponding to the credit risk assessment of the asset derivative positions as "Credit Valuation Adjustment" (CVA) and liabilities derivative position as "Debit Valuation Adjustment" (DVA), was not material.

Financial assets and liabilities classified as Level 3

The changes in the balance of Level 3 financial assets and liabilities included in the accompanying consolidated balance sheets are as follows:

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Financial Assets Level 3 Changes in the Period	Millions of Euros
	2013		2012		2011
	Assets	Liabilities	Assets	Liabilities	Assets	Liabilities
Balance at the beginning	1,165	55	1,764	23	1,469	25
Valuation adjustments recognized in the income statement (*)	7	15	51	2	(1)	(12)
Valuation adjustments not recognized in the income statement	-	-	(3)	-	-	-
Acquisitions, disposals and liquidations	(374)	(18)	(279)	29	266	9
Net transfers to Level 3	180	-	(134)	-	33	-
Exchange differences and others	(95)	(1)	(233)	1	(3)	1
Exchange differences and others	881	52	1,165	55	1,764	23

(*) Profit or loss that is attributable to gains or losses relating to those assets and liabilities held at the end of the reporting period

As of December 31, 2013, the profit/loss on sales of financial instruments classified as level 3 recognized in the accompanying income statement was not material.

Transfers between levels

The Global Valuation Area, in collaboration with the Technology and Methodology Area, has established the rules for a proper trading portfolio asset classification according to the fair value hierarchy defined by international accounting standards.

On a monthly basis, any new assets registered in the portfolio are classified, according to this criterion, by the generating subsidiary. Then, there is a quarterly review of the portfolio in order to analyze the need for a change in classification of any of these assets.

The financial instruments transferred between the different levels of measurement in 2013 are at the following amounts in the accompanying consolidated balance sheets as of December 31, 2013:

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	Millions of Euros
	From:	Level I		Level 2		Level 3
Transfer between levels	To:	Level 2	Level 3	Level 1	Level 3	Level 1	Level2
ASSETS
Financial assets held for trading		-	5	18	2	-	3
Available-for-sale financial assets		7	190	172	-	5	9
LIABILITIES-

Sensitivity Analysis

Sensitivity analysis is performed on products with significant unobservable inputs (products included in level 3), in order to obtain a reasonable range of possible alternative valuations. This analysis is carried out on a monthly basis, based on the criteria defined by the Global Valuation Area taking into account the nature of the methods used for the assessment and the reliability and availability of inputs and proxies used. In order to establish, with a sufficient degree of certainty, the valuating risk that is incurred in such assets without applying diversification criteria between them.

As of December 31, 2013, the effect on the consolidated income and consolidated equity of changing the main hypotheses used for the measurement of Level 3 financial instruments for other reasonably possible models, taking the highest (most favorable hypotheses) or lowest (least favorable hypotheses) value of the range deemed probable, would be as follows:

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Financial Assets Level 3 Sensitivity Analysis	Millions of Euros
	Potential Impact on Consolidated Income Statement		Potential Impact on Total Equity
	Most Favorable Hypothesis	Least Favorable Hypothesis	Most Favorable Hypothesis	Least Favorable Hypothesis
ASSETS
Financial assets held for trading	16	(13)	-	-
Available-for-sale financial assets	-	-	11	(11)
LIABILITIES-
Financial liabilities held for trading	1	(1)	-	-
Total	17	(14)	11	(11)

8.2 Fair value of financial instruments carried at cost using valuation criteria

The valuation methods used to calculate the fair value of financial assets and liabilities carried at cost are presented below:

• The fair value of "Cash and balances with central banks" has been assimilated to their book value, as it is mainly short-term balances.
• The fair value of the "Loans and advances to customers" and "financial liabilities at amortized cost" was estimated using the method of discounted expected future cash flows using market interest rates at the end of each year. Additionally, factors such as prepayment rates and correlations of default are taken into account.

The following table presents key financial instruments carried at amortized cost in the accompanying consolidated balance sheets, broken down according to the method of valuation used to estimate their fair value:

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Fair Value by Levels		Millions of Euros
	Notes	2013			2012			2011
			Level 1	Level 2	Level 3	Level 1	Level 2	Level 3	Level 1	Level 2	Level 3
ASSETS-
Cash and balances with central banks	9	34,903	-	-	35,494	-	-	29,841	-	-
Loans and receivables	13		1,351	362,769	-	-	391,594	-	-	377,722
LIABILITIES-
Financial liabilities at amortized cost	23	-	-	466,240	-	-	488,163	-	-	459,698

The main valuation methods, hypotheses and inputs used to estimate the fair value of financial instruments accounted for at cost and classified in levels 2 and 3 is shown below. These are broken down by type of financial instrument and the balances correspond to those at December 31, 2013:

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Financial Instruments Level 2	Fair Value (Millons of euros)	Main Measurement techniques	Main inputs used
Loans and receivables		Present-value method (Discounted future cash flows)	– Default correlation – Credit spread
Debt securities	1,351

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Financial Instruments Level 3	Fair Value (Millons of euros)	Main Measurement techniques	Main inputs used
Loans and receivables		Present-value method (Discounted future cash flows)	– Prepayment rates – Default correlation – Credit spread – Market interest rates
Loans and advances to credit institutions	22,147
Loans and advances to customers	337,742
Debt securities	2,881
Financial liabilities at amortized cost
Deposits from central banks	31,018
Deposits from credit institutions	51,859
Customer deposits	301,187
Debt certificates	64,984
Sobordinated liabilities	11,206
Other financial liabilities	5,985

Financial instruments at cost

As of December 31, 2013, 2012 and 2011, there were equity instruments and certain discretionary profit-sharing arrangements in some entities which were recognized at cost in the Group’s consolidated balance sheets because their fair value could not be reliably determined, as they were not traded in organized markets and, thus, their unobservable inputs are significant. On the above dates, the balances of these financial instruments recognized in the portfolio of available-for-sale financial assets amounted to €516, €510 million and €541 million, respectively.

The table below outlines the financial assets and liabilities carried at cost that were sold in the year ended December 31, 2013, 2012 and 2011:

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Sales of financial instruments at cost	Millions of Euros
	2013	2012	2011
Amount of Sale	76	29	19
Carrying Amount at Sale Date	62	5	8
Gains/Losses	13	24	11