BEFORE THE Stockholm District Court HQ AB v. Mats Qviberg, …/media/Files/H/Hqab/utredning/hqab... · 2014. 11. 6. · demonstrating competence in the investment valuation and decision-making

BEFORE THE

Stockholm District Court

HQ AB

PLAINTIFF

v.

Mats Qviberg, Stefan Dahlbo, Curt Lönnström, Thomas Erséus, Mikael König, Johan Piehl, Carolina Dybeck Happe, Anne-Marie Pålsson, Pernilla Ström, Johan Dyrefors, KPMG AB

(registration no. 556043-4465), and Investment AB Öresund (registration no. 556063-9147) (the “Defendants”)

EXPERT REPORT

ON DERIVATIVE PORTFOLIO VALUATIONS

BRENT C. KACZMAREK, CFA

NAVIGANT CONSULTING, INC.

1200 19th Street Suite 700

WASHINGTON, DC 20036

22 February 2013

Page i

Table of Contents

I. Scope of Work and Qualifications ............................................................................................ 1

II. My Assessment of the Bank’s Valuation Rules in the Context of IAS 39 and IFRS 7 ......... 2

A. Basic Valuation Parameters Established by IAS 39 ..................................................................... 3

B. Examination of HQ Bank’s Rules of Procedure for Trading ....................................................... 5

C. My Review of the Methodology HQ AB Adopted to Value HQ Bank’s Trading Portfolio ........ 6

i. The 2007 Financial Statements ............................................................................................. 6

ii. The 2008 Financial Statements ........................................................................................... 11

iii. The 2009 Financial Statements ........................................................................................... 16

D. My Overall Opinion on the Methodologies HQ Bank Adopted to Value its Derivative Trading Portfolio ........................................................................................................................................... 18

III. My Examination and Review of HQ Bank’s Trading Portfolio ........................................... 22

A. Overview of the Manner in Which My Examination and Review was Carried Out .................. 22

i. Volatility Reviews ............................................................................................................... 22

ii. Daily Reviews ..................................................................................................................... 28

iii. HQ Bank Trading Files ....................................................................................................... 28

iv. Data and Trading Statistics from the Eurex Exchange ....................................................... 29

v. Data and Trading Statistics from Nasdaq OMX Exchange ................................................. 30

vi. Process Used to Incorporate External Data into the Volatility Reviews ............................. 30

B. Evaluation of the Trading Portfolio and HQ Bank’s Valuation Methods between 2007 and 2010 ............................................................................................................................................. 34

i. Investigation of Positions and Valuations Creating the Edge ............................................. 37

ii. Edges that Straddle Year-End Financial Reporting Dates .................................................. 52

iii. The Volatility Factor in the Bank’s Theoretical Market Valuation .................................... 58

iv. Rolling Edge ........................................................................................................................ 61

v. Analysis of Positions at Year-End 2007, 2008, and 2009 ................................................... 63

(a) Year-End 2007 .................................................................................................................... 63

(b) Year-End 2008 .................................................................................................................... 65

(c) Year-End 2009 .................................................................................................................... 67

C. Conclusions Regarding the Bank’s Financial Reporting of the Performance of the Trading Portfolio from 2007 to 2010 ............................................................................................................ 70

Page i

Listing of Tables

Table 1 – Subsequent Measure of Financial Instruments on HQ’s Financial Statements ................. 7

Table 2 – Description of Fair Value Measurement in HQ AB’s 2006 and 2007 Financial Statements .......................................................................................................................................... 8

Table 3 – HQ Bank’s Method for Determining Fair Value in 2007 ................................................ 10

Table 4 – HQ Bank’s Methods for Determining Fair Value in 2008 versus 2007 .......................... 14

Table 5 – HQ Bank’s Methods for Determining Fair Value in 2009 versus 2008 .......................... 18

Table 6 – 2009 Fair Value Methodology as a Percent of Total Derivatives .................................... 20

Table 7 – Description of Relevant Fields to my Review in the Volatility Reviews ........................ 24

Table 8 – Comparison of Asset Values between Volatility Reviews and HQ Group Audited Balance Sheets ................................................................................................................................. 26

Table 9 – Sample of Monthly Trading Data from the Eurex Exchange – Call Option on the ODAX with a Strike Price of €5,800 and Expiration in March 2010 .......................................................... 29

Table 10 –Volatility Reviews for OMXS30 Calls with a Strike Price of SEK 660 and SEK 700 and Expiration of 22 January 2010 ......................................................................................................... 38

Table 11 – Trade Data for OMXS30 Call Strike SEK 660 and SEK 700 Expiration 22 Jan 2010 . 40

Table 12 – Daily Volatility Reviews for OMXS30 Calls with Strike Prices of SEK 660 and SEK 700 and Expiration of 22 January 2010 ........................................................................................... 41

Table 13 – Positions with Inactive Orders at 30 June 2009 ............................................................. 42

Table 14 – Volatility Reviews for OMXS30 Puts with Strike Prices of SEK 980 and SEK 940 and Call with Strike Price of SEK 860 with Expiration 22 January 2010 .............................................. 43

Table 15 — HQ Bank Trade Data for OMXS30 Puts with Strike Prices of SEK 980 and SEK 940 and Call with Strike Price of SEK 860 with Expiration 22 January 2010 ....................................... 44

Table 16 – Quoted Market Prices on 22 Dec 2008 for OMXS30 Puts and Calls with Expiration 22 January 2010 .................................................................................................................................... 45

Table 17 – Change in HQ Bank’s DAX Call and Put Positions Expiring 18 June 2010................. 48

Table 18 – Transactions Involving Call Options on the DAX with Strike Price of €5,300 and Expiration Date of 18 December 2009 ............................................................................................ 50

Table 19 – Historical Volatility and ATM Implied Volatility for DAX Options Expiring 18 December 2009 ................................................................................................................................ 60

Table 20 – Historical Volatility and ATM Implied Volatility for OMX Options Expiring 25 January 2008 .................................................................................................................................... 61

Table 21 – Top Positions by Navigant Edge as of 18 December 2007 ........................................... 64



Page ii

Table 24 – Losses Associated with the 18 Incorrectly Valued Positions ........................................ 69

Table 25 – NCI Calculated Edge Compared to the Carrying Value of the Derivative Portfolio, Profits of HQ Bank, and Derivative Trading Profits/Losses ........................................................... 72

Page iii

Listing of Figures

Figure 1 – Market Implied Volatilities for NOA3 Put Options as of 22 December 2008 ............... 15

Figure 2 – Market Implied Volatilities for HMB Call Options as of 22 December 2008 ............... 16

Figure 3 – Nordea 2009 Disclosure of Opening and Closing Balances for Level 3 ........................ 21

Figure 4 – Decision Rules for Incorporating Eurex and Nasdaq OMX Market Prices ................... 33

Figure 5 – Evolution of HQ Bank Edge and Navigant Edge for Put and Call Options ................... 35

Figure 6 – Navigant Edge for Put and Call Options by Underlying Security ................................. 36

Figure 7 – Revised Evolution of HQ Bank’s Edge for Put and Call Options .................................. 46

Figure 8 – Navigant Edge for Put and Call Options by Assets and Liabilities ................................ 47

Figure 9 – Movement in the DAX from 28 July 2009 to 25 August 2009 in SEK ......................... 49

Figure 10 – Aggregate Theoretical and Market Results for HQ Bank’s Liability DAX Call Options with a Strike Price of €5,300 and Expiration of 18 December 2009 ............................................... 51

Figure 11 – Aggregate Theoretical and Market Results for HQ Bank’s DAX Call Options with a Strike Price of €6,200 and Expiration of 19 March 2010 ................................................................ 53

Figure 12 – Transaction Price and Reported Theoretical Fair Value for HQ Bank’s DAX Call Options with a Strike Price of €6,200 and Expiration of 19 March 2010 ....................................... 54

Figure 13 – Aggregate Theoretical and Market Results for HQ Bank’s Liability DAX Call Options with a Strike Price of €5,000 and Expiration of 18 December 2009 ............................................... 56

Figure 14 – Aggregate Theoretical and Market Results for HQ Bank’s Liability OMXS30 Call Options with a Strike Price of SEK 1,300 and Expiration of 23 January 2009 ............................... 58

Figure 15 – Navigant Edge for HQ Bank’s Options on the OMXS30 and DAX Indices at Various Expiration Dates ............................................................................................................................... 62

Page 1

I. Scope of Work and Qualifications

1. Navigant Consulting, Inc. (“Navigant”) has been asked by HQ AB (“Claimant”) through its counsel

Frank Advokatbyrå AB (“Counsel”) to prepare this expert report in the disputes arising subsequent to the

liquidation and sale of HQ Bank following the decision of the Swedish Financial Supervisory Authority,

Finansinspektionen (“FI”), to revoke HQ Bank’s license to conduct banking and securities business and

its license to be registered as a fund manager (“the Decision”). I understand that Claimant alleges that

the Decision was caused by the negligent acts of the Board of Directors of HQ AB, the Board of Directors

of the Bank, the Managing Director, and the auditor of HQ AB and HQ Bank (collectively “Defendants”)

in carrying out their respective duties during the period from 2007 to 2010. I also understand that the

Claimant asserts that the distribution of dividends from HQ AB in respect of the financial years 2007

through 2009 was unlawful.

2. I have been asked to prepare this expert report to assist the Court with financial matters in this

litigation that may be relevant to the Court’s determination of liability. Specifically, I have been asked by

Claimant to offer my independent, expert opinion on two different matters.

3. First, as a valuation professional, I have been asked to comment on the methodology HQ Bank

adopted in the valuation of the derivatives in its portfolio in the context of International Accounting

Standard 39 (“IAS 39”) and International Financial Reporting Standard 7 (“IFRS 7”).

4. Second, I have been asked to review financial information and data concerning HQ Bank’s

proprietary trading portfolio from May 2007 to May 2010 and to determine whether or not the reported

financial performance of the portfolio accurately reflected the profits and losses that were being generated

by the Bank’s trading activities. To the extent that I believe HQ Bank did not properly value its

proprietary trading portfolio, I have been asked to quantify any difference in the value at certain specific

points in time – year-end 2007, 2008 and 2009 using the data available to me.

5. This report does not contain any opinions on matters of law that would require legal expertise. This

report also does not address any issues concerning auditing practices and standards.

6. I am a Managing Director in the Washington, D.C. office of Navigant. I lead Navigant’s

International Arbitration practice and have served (or am serving) as a financial, valuation, and damages

expert in approximately 90 international arbitrations, including more than 70 investor-state arbitrations in

which I have been appointed by both investors and states in a balanced proportion. In 1998, I received

the designation of Chartered Financial Analyst from the Association for Investment Management and

Research (now CFA Institute). This globally recognized designation is held by professionals

Page 2

demonstrating competence in the investment valuation and decision-making process. My current

curriculum vitae is provided as Appendix 1 to this report.

7. Over the past 13 years, I have been involved in and have served as an expert in international

arbitrations involving bank solvency, bank restructuring, and bank valuation issues. I have written expert

opinions addressing the manner in which banks were restructured in Eastern Europe following the

collapse of the Soviet Union. In particular, I have analyzed bank failures and bank restructuring programs

implemented in the Czech Republic, Slovakia, and to a lesser degree Hungary and Poland. I have also

written expert opinions dealing with bank failures and restructurings that occurred in the Czech Republic

and Slovakia following the Russian crisis in early 1998. In South America, I have been involved in cases

dealing with bank failures and restructurings that occurred in Peru in 2000 following external shocks, and

those in Argentina in 2001 following its sovereign debt default, devaluation, and pesification. My work

has also consisted of specific investigations and a detailed review of various transactions and accounting

practices undertaken at specific banks that ultimately contributed to the insolvency of those banks. I have

presented expert evidence on the manner in which certain transactions were structured and accounting

practices undertaken to ascertain the impact of them on the reported financial situation of the bank. The

scope of work I have been asked to perform in this litigation is similar to the work I have previously

undertaken in other expert assignments before international arbitral tribunals.

8. Some of the documents I have reviewed in this matter were originally prepared in Swedish.

Although I have served as an expert witness in many arbitrations involving companies and countries in

Europe including Sweden, I do not speak or write in Swedish. Accordingly, I have relied upon

translations of these documents or translation services provided by Counsel. The list of documents I

relied upon in preparing this report is provided as Appendix 2.

9. If additional documents or facts come to my attention which might have a bearing on my review of

HQ Bank’s proprietary trading portfolio, I reserve the right to modify my conclusions.

II. My Assessment of the Bank’s Valuation Rules in the Context of IAS 39 and IFRS 7

10. As a valuation professional, I have been asked to comment on the methodology HQ Bank adopted in

the valuation of the securities and derivatives in its portfolio in the context of IAS 39 and IFRS 7. In

order to do so I examined the Rules of Procedure for Trading that were issued by the Board of Directors

of HQ Bank and, the notes in HQ AB’s financial statements from 2007 to 2009 describing the accounting

policies applied to value and report HQ Bank’s financial instruments. In this section, I first discuss the

basic rules and parameters set forth in IAS 39. This is followed by my review of HQ Bank’s Rules of

Procedure for Trading as it relates to valuation matters. I then discuss my review of HQ AB’s description

Page 3

of the methodology HQ Bank used to value its trading portfolio and highlight significant changes in the

language used over time. Finally, I present my conclusions on the valuation methodology HQ AB states

HQ Bank was employing in preparing its financial statements.

A. Basic Valuation Parameters Established by IAS 39

11. IAS 39 sets forth the methodologies and parameters to be used in determining fair value for certain

assets and liabilities. IAS defines fair value as the “price agreed by a willing buyer and willing seller in

an arm’s length transaction.”1

12. IAS 39 states that the best evidence of fair value is quoted prices in an active market. IAS 39 does

not define an active market, but describes the characteristics of an active market.

“A financial instrument is regarded as quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices represent actual and regularly occurring market transactions on an arm’s length basis.”2

13. The use of the terms “actually and regularly occurring” leave open for interpretation the definition of

active market. IAS 39 also states that bid and ask prices should be used when the asset or liability is

traded on an active market.3 In the absence of bid and ask prices, IAS 39 states that the next best

indicator of value is the most recent transaction price so long as the economic circumstances have not

changed materially between the last transaction price date and the measurement date.4

14. In the absence of quoted prices on an active market, IAS 39 states that a valuation technique should

be utilized to establish fair value.5 IAS 39 makes clear, however, that the valuation technique should

establish what the price “would have been on the measurement date in an arm’s length exchange

motivated by normal business considerations.”6 When using a valuation technique, IAS 39 states that the

1 International Accounting Standard 39 Financial Instruments: Recognition and Measurement, para. AG 71, (NAV-1) 2 International Accounting Standard 39 Financial Instruments: Recognition and Measurement, para. AG 71, (NAV-1) 3 International Accounting Standard 39 Financial Instruments: Recognition and Measurement, para. AG 71, AG 72, (NAV-1) 4 International Accounting Standard 39 Financial Instruments: Recognition and Measurement, para. AG 72, (NAV-1)

5 International Accounting Standard 39 Financial Instruments: Recognition and Measurement, para. AG 74, (NAV-1)


Page 4

technique should make maximum use of market inputs and rely as little as possible on subjective inputs

determined by the valuation practitioner.7

“The objective of using a valuation technique is to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations. Fair value is estimated on the basis of the results of a valuation technique that makes maximum use of market inputs, and relies as little as possible on entity-specific inputs. A valuation technique would be expected to arrive at a realistic estimate of the fair value if (a) it reasonably reflects how the market could be expected to price the instrument and (b) the inputs to the valuation technique reasonably represent market expectations and measures of the risk-return factors inherent in the financial instrument.”8

15. Thus, IAS 39 creates a hierarchy of valuation evidence that it considers to be appropriate in

determining fair value: 1) quoted prices in an active market, 2) recent transactions conducted in the

market, 3) a valuation technique maximizing the use of market derived inputs.9

16. For financial reporting purposes, IFRS 7 requires entities to disclose the total value of those assets

and liabilities that have been determined through a hierarchy as well. IFRS 7 also establishes 3 levels of

financial reporting that relate to the hierarchy under IAS 39, but its levels are slightly different.10 IFRS 7

states that valuations conducted using quoted prices in active markets or recent transactions should be

reported as Level 1 valuations. Valuations conducted using valuation techniques with market based

parameters should be reported as Level 2 valuations. Finally, valuations conducted using valuation

techniques with non-market based parameters should be reported as Level 3 valuations.11

17. With respect to the initial recognition of an asset or liability in the financial statements, IAS 39 states

that the most reliable evidence of value is the transaction price unless:

“the fair value of that instrument is evidenced by comparison with other observable current market transactions in the same instrument (ie without



9 International Accounting Standard 39 Financial Instruments: Recognition and Measurement, para. AG 69- AG 82, (NAV-1)

10 International Financial Reporting Standard 7, Financial Instruments, para. 27A, (NAV-2); IFRS 7, Paragrah 27A became effective on 1 January 2009.

11 International Financial Reporting Standard 7, Financial Instruments, para. 27A, (NAV-2)

Page 5

modification or repackaging) or based on a valuation technique whose variables include only data from observable markets.”12

18. Thus, if observable market transactions or a valuation technique using only observable market

parameters can be implemented, IAS 39 allows for an asset or liability to be valued in this way

immediately after initial recognition.13 This immediate revaluation of the asset or liability is typically

referred to as the “day 1 result.” The day 1 result can obviously be a day 1 loss or a day 1 profit.

19. Examples of observable market inputs include quoted prices for similar assets or interest

rates. KPMG considers the following to be observable market inputs as stated in its guidelines on

practical issues pertaining to fair value, entitled “IFRS Practice Issues: Fair Value Hierarchy”.

“Transaction prices in markets that are not active for identical instruments.

Quoted prices in active markets for similar, but not identical, instruments.

Transaction prices in markets that are not active for similar, but not identical, instruments.

Implied volatilities derived from quoted option prices.”14

B. Examination of HQ Bank’s Rules of Procedure for Trading

20. I have been provided with a copy, in English, of the Rules of Procedure for Trading for HQ Bank.15

I have reviewed this document to understand the methodologies the Bank has adopted in the valuation of

its proprietary trading portfolio, and in particular, the derivative positions it historically established.

There were aspects of this document which were surprising to me upon my review.

21. The rules of procedure indicate that both market valuations as well as theoretical valuations should

be conducted by the Bank on its derivative positions. While these two measurements were not surprising

by themselves, it was surprising to see that the rules of procedure stated that:



14 KPMG, IFRS Practice Issues: Fair Value Hierarchy, International Financial Reporting Standards, 2009, p.10, (NAV-3)

15 Rules and Procedures for Trading Memorandum issued by HQ Bank’s Board of Directors, 13 December 2000 (as amended), (NAV-4)

Page 6

“When evaluating derivatives, the calculated theoretical value will form the basis for accounting and the calculation of profits.”16

22. This directive appears to be in direct contradiction to IAS 39 which states that quoted prices or

recent transaction prices should be preferred over a theoretical valuation technique. However, whether or

not the valuations undertaken by the Bank resulted in a value inconsistent with fair value must be

reviewed first before concluding whether or not the Bank ultimately complied with IAS 39 given this

directive. Indeed, I note that the rules of procedure state that:

“At the end of each month or at some other selected time, R/F/K performs a control valuation of all the instruments in the trading portfolio by comparing prices in ORC against external sources, as well as checking and specifically commenting on the consistency of selected parameters in the theoretical valuation.”17

23. Thus, it appears that HQ AB intended to use theoretical valuation techniques that could be

reconciled with market based valuation evidence.18

C. My Review of the Methodology HQ AB Adopted to Value HQ Bank’s Trading Portfolio

24. For purposes of presentation, I have segmented my review of HQ AB’s valuation policies as

disclosed in their annual reports and financial statements into sections by year.

i. The 2007 Financial Statements

25. In 2007, HQ AB’s financial statements indicate that financial instruments were initially measured at

the cost corresponding to the instrument’s fair value.19 After initial recognition, the value of the financial

instruments was determined based on the classification assigned to each instrument.20 HQ AB classified

16 Rules and Procedures for Trading Memorandum issued by HQ Bank’s Board of Directors, 13 December 2000, (as amended),

p. 2, (NAV-4) 17 Rules and Procedures for Trading Memorandum issued by HQ Bank’s Board of Directors, 13 December 2000, (as amended),

p. 3, (NAV-4)

18 I also found it surprising that the rules and procedures asked for the calculation of an “edge”. The edge appears to be the difference between the profit/loss recorded in the financial statements (which relies on theoretical valuation techniques) and the profit/loss that relies on a market based valuation. If you use theoretical valuation techniques in your financial reporting you should always be calibrating your valuation. From the calibration, banks will be able to determine if the theoretical valuation technique results in a value to their advantage or disadvantage. However, in using the word edge, HQ Bank appears to suggest that they are always using the valuation technique to their advantage.

19 HQ AB 2007 Annual Report, p. 49, (NAV-5) 20 HQ AB 2007 Annual Report, p. 49, (NAV-5)

Page 7

each asset and liability based on: 1) the purpose for which the instrument was acquired and 2) the rules

provided in IAS 39.21

“Financial instruments are initially measured at a cost corresponding to the instrument’s fair value including transaction costs, except those in the category of financial assets at fair value through profit or loss, which are reported at fair value excluding transaction expenses.

Financial instruments are subsequently measured according to how they were classified, as below. At initial recognition, financial instruments are classified in part based on the purpose for which the instrument was acquired, but also based on the options provided in IAS 39.”22

26. Table 1 below shows the valuation method used to value financial instruments assigned to each

category and the income statement account where changes in the value of the instruments were

recognized.

Table 1 – Subsequent Measure of Financial Instruments on HQ’s Financial Statements23

27. HQ AB classified financial instruments in the trading portfolio under the categories financial assets

or liabilities at fair value through profit or loss.24 HQ AB defined this category in the 2007 financial

statements as instruments acquired in order to be sold in the short term.25 The notes to the 2007 financial

statements indicate that the financial instruments in this category were measured regularly at fair value

and that any change in the fair value was recognized in the income statement under the account “Net Gain

or Loss from Financial Transactions.”26

21 HQ AB 2007 Annual Report, p. 49, (NAV-5) 22 HQ AB 2007 Annual Report, p. 49, (NAV-5) 23 HQ AB 2007 Annual Report, pp. 49-50, (NAV-5) 24 HQ AB 2007 Annual Report, pp. 49-50, (NAV-5) 25 HQ AB 2007 Annual Report, p. 49, (NAV-5) 26 HQ AB 2007 Annual Report, p. 49, (NAV-5)

Type of Financial Instruments Measurement Changes in Carrying Amount Recognized on

Financial Assets at Fair Value through Profit / Loss Fair ValueIncome Statement - Net Gain or Loss from Financial Transactions

Loans and Accounts Receivables Amortized Cost Income Statement - Net Credit Losses

Financial Liabilities at Fair Value through Profit / Loss Fair ValueIncome Statement - Net Gain or Loss from Financial Transactions

Other Financial Liabilities (not held for trading) Amortized Cost Income Statement - Net Credit Losses

Page 8

28. I reviewed HQ AB’s 2006 financial statements to determine how HQ Bank measured fair value in

that year. My review indicated that HQ AB modified its explanation of how fair value was measured in

2007. In 2006, HQ AB indicated that market prices were used to determine the fair value of financial

instruments.27 However in 2007, HQ AB added the caveat that market prices were used to determine the

fair value of financial instruments only when quoted on active markets.28 Table 2 below highlights the

difference in the language between the two years.

Table 2 – Description of Fair Value Measurement in HQ AB’s 2006 and 2007 Financial Statements29

29. The notes to the 2007 financial statements do not define an active market, but the concept of an

active market is one recognized under IAS 39. The 2007 financial statements also stated that if the

quoted market price for a financial instrument did not represent actual and regularly occurring market

transactions, the fair value of the instruments was determined using valuation models based on input from

observable market prices. If inputs from observable market prices were not available, HQ Bank relied on

non-observable parameters.30 The 2007 financial statements do not discuss the factors the group

considered to determine if the quoted market prices represented actual and regularly occurring market

transactions.

“If quoted market prices for a financial instrument do not represent actual and regularly occurring market transactions, or if no quoted

27 HQ AB 2006 Annual Report, p. 41, (NAV-6) 28 HQ AB 2007 Annual Report, p. 50, (NAV-5) 29 Only material changes in the notes are highlighted. Words in red strikethrough indicate they have been eliminated since the

previous year. Words in blue indicate words added in current year. HQ AB 2006 Annual Report, p. 41, (NAV-6); and HQ AB 2007 Annual Report, pp. 50-51, (NAV-5)

30 HQ AB 2007 Annual Report, p. 50, (NAV-5)

2006 2007The fair value of listed financial assets corresponds to the asset’s listed purchase price on the reporting date. The fair value of unlisted financial assets is established by using valuation techniques such as recently conducted transactions, prices of similar instruments and discounted cash flows.

With respect to financial assets, the fair value of listed financial instruments with quoted market prices in an active market corresponds to the current bid price on balance sheet date, and with respect to financial liabilities to the current offer price... The fair value of unlisted financial assets is determined using valuation techniques such as recently executed transactions, prices of comparable instruments and discounted cash flows.

Page 9

market prices are available, fair value is determined using a valuation technique. Valuation techniques may vary from simple analysis of discounted cash flows to complex option valuation models.

The valuation models have been designed in such a way that observable market prices are used as input data were available, but they may also use non-observable model parameters. In the majority of cases, HQ uses valuation techniques to determine the fair value of instruments recognised in the following balance sheet items: Investments in associates (when quoted market prices in an active market are unavailable), Derivatives.”31

30. Thus, HQ Bank had three levels of classification when determining the fair value of financial

instruments – Level 1, instruments with quoted market prices; Level 2, valuation techniques based on

observable market data; and, Level 3, valuation techniques based on non-observable market data. These

categories are consistent with IAS 39. However, the 2007 financial statements do not disclose the sum

total of financial instruments that were valued at each level. I noticed that HQ AB began providing this

detail in its 2008 financial statements (which also contains the 2007 financials for historical reference).

Table 3 below summarizes the total value of financial instruments that were valued under each level as of

year-end 2007.


Page 10

Table 3 – HQ Bank’s Method for Determining Fair Value in 200732

31. Table 3 above reveals that HQ AB only used quoted market prices (Level 1) to determine the fair

value of positions in equity shares. All derivatives (both assets and liabilities) were valued under Levels 2

or 3. Indeed, 37 percent of the asset positions and 76 percent of the liability positions were valued using

non-observable market data. This implies that either a quoted market price was not available for the

derivative instruments or that management determined the quoted market prices did not represent actual

and regularly occurring market transactions (i.e. the market was considered inactive).

32. With respect to Level 2 and Level 3 valuations, the 2007 financial statements indicate that HQ AB

employed valuation techniques which are less objective than quoted market prices and require varying

degrees of judgment from management.33 Management used their judgment to select the appropriate

valuation model to be used, the inputs to be used in the model (such as volatility and discount rates), and

the probability of counterparty and liquidity risks.

“Fair value is measured as the theoretical present value of the individual contracts, based on market parameters taken from independent sources and assuming that no risks and no uncertainty exist. This measurement is augmented with an adjustment at the portfolio level. Adjustment at the

32 HQ AB 2008 Annual Report, p. 68, Note 29, (NAV-7)


Observable Market Data

Non-observable Market Data

(Amounts in SEK millions) Level 1 Level 2 Level 3 Total

Assets

Derivatives - 964 572 1,536 Shares and Participants 2,214 - - 2,214

Total 2,214 964 572 3,750

Level as a % of Total Derivatives 0% 63% 37% 100%Liabilities

Derivatives - 391 1,228 1,619 Securities Loans 504 - - 504

Total 504 391 1,228 2,123

Level as a % of Total Derivatives 0% 24% 76% 100%

2007

Valuation Techniques Based onInstruments with Quoted

Market Prices

Page 11

portfolio level refers to uncertainty related to valuation techniques, the assumptions applied in the models and non-observable parameters, as well as counterparty risk and liquidity risk attributable to the portfolio.

When the fair value of financial instruments is estimated using a valuation technique, a study is performed of whether the variables used in the valuation model were exclusively based on data obtained from observable markets. HQ considers data from observable markets to be data which may be obtained from generally available external sources and which are assessed as realistic market prices.”34

33. The 2007 financial statements also stated that HQ AB used widely recognized valuation models for

determining the fair value of options based on the implicit volatility in similar securities or historical

volatility of the underlying security.

“Theoretical valuation is based on accepted models for valuation of options. For American stock options the binomial model is normally used (put options) and Geske (call options), while Black & Scholes is used for European stock options and index options. Volatility is the most important parameter estimated for theoretical valuation of derivative instruments. These estimates are based on implicit volatility in similar securities as well as historical volatility in the particular underlying security.”35

ii. The 2008 Financial Statements

34. My review of the 2008 HQ AB financial statements revealed three important changes in the

language used to describe the valuation and reporting rules of financial instruments.

35. First, the financial statements included additional language which narrowed the definition of an

active market. Specifically, HQ AB used the size of its position in a particular financial instrument to

determine whether the market was active for that instrument.36

“If HQ accounts for a significant proportion of the trade in a particular financial instrument this affects the opinion as to whether or not the market for that specific instrument is active. The reason for considering this circumstance in assessing whether or not the market for a particular instrument is active is to eliminate the risk of individual traders, through unusual transactions, influencing the market price and, by extension, the

34 HQ AB 2007 Annual Report, p. 50, (NAV-5) 35 HQ AB 2007 Annual Report, p. 51, (NAV-5) 36 HQ AB 2008 Annual Report, Note 1, p. 46, (NAV-7)

Page 12

company’s valuation in the statement of comprehensive income and statement of financial position.”37

36. Second, HQ AB disclosed that it was no longer relying on the volatility of the underlying instrument

or the implicit volatility measurements obtained from similar instruments in executing its Level 2 and

Level 3 valuations. Instead, the new disclosure explained that the valuation technique reflected in HQ

Bank’s trading strategy was mean reversion, or the idea that the volatility of options would move towards

its historical average.

“Theoretical valuation is based on accepted models for valuation of options. For American options the binomial model is normally used (put options) and Geske (call options), while Black & Scholes is used for European stock options and index options. Volatility is the most important parameter estimated for theoretical valuation of derivative instruments. These estimates are based on implicit volatility in similar securities as well as historical volatility in the particular underlying security. The theoretical valuation of options is based on a trading strategy called mean reversion, which is based on the assumption that the volatility of options will move towards a historical average. All option prices that deviate from the historical average are regarded as incorrectly priced. This means that future volatility is estimated based on historical volatility rather than implicit volatility. The models are also based on all options with the same underlying exposure and the same expiration having the same volatility, irrespective of strike price.” (Additional wording shown in blue underlined font and language removed shown in red strikethrough font)

38

37. Moreover, the 2008 financial statements no longer included any language explaining that the

determination of fair value was adjusted to take into account uncertainty related to the valuation

techniques, model assumptions, liquidity, and counterparty risks.39

38. Third, HQ AB disclosed that it began recognizing “day 1” results. Day 1 results refer to the

recognition of a profit or loss on the same day the financial instrument is sold or acquired. In essence,

HQ Bank would record the purchase or sale of a financial instrument and revalue that instrument on the

same day with a difference being recorded as profit or loss.

37 HQ AB 2008 Annual Report, Note 1, p. 47, (NAV-7) 38 HQ AB 2008 Annual Report, Note 1, p. 47, (NAV-7) 39 HQ AB 2007 Annual Report, p. 50, (NAV-5); HQ AB 2008 Annual Report, Note 1, pp. 46-47, (NAV-7)

Page 13

“Any gain or loss that arises in conjunction with valuation using theoretical models when a financial instrument is initially recognised in the statement of financial position, a day 1 gain or loss, has not been assessed as tangible and is thus recognized directly in profit and loss.”40

39. I find the valuation policy changes of HQ Bank to be very controversial for four reasons.

40. First, the revised definition of active market wrongly considered the size of HQ Bank’s position in a

particular instrument. Essentially, HQ AB disclosed that if the Bank established a very large position in a

particular instrument, and even if that instrument traded regularly at volumes less than its total position,

then the trading price would not be utilized for valuation purposes. In my view, the use of a Level 2 or 3

valuation technique under this policy had the ability to create a distortion in the Bank’s financial reporting

due to the difference between the price of the financial instrument recorded in the financial statements and

the trading price of the financial instrument. Such difference might be justified if the valuation technique

resulted in a lower price than the trading price for asset positions and a higher price than the trading price

for liability positions due to the heightened risk of holding a large position. The notes to the financial

statements do not indicate if the valuation technique results in a more conservative valuation in these

circumstances.

41. Second, HQ AB’s disclosure that HQ Bank’s valuation techniques incorporated its “trading strategy”

is misplaced. While it may be a perfectly valid trading strategy to purchase options where the historical

volatility of the underlying security has been more volatile and sell options where the historical volatility

of the underlying security has been less volatile, and hope that the volatility reverts to the historical mean

(thus generating a potential profit) a trading strategy is an irrelevant consideration for valuation purposes.

In essence, HQ AB disclosed that HQ Bank was valuing derivative instruments at prices it hoped the

instruments would be trading at in the future rather than the present.

42. Third, while HQ Bank’s adoption of “day 1” results is supported by IAS 39 when compelling market

data substantiates a “day 1” result, HQ AB disclosed that it almost never relied on market data in its

valuation of the derivatives portfolio.41 Table 4 below compares the total of derivatives valued at each

level in 2007 and 2008.

40 HQ AB 2008 Annual Report, Note 1, p. 47, (NAV-7) 41 International Accounting Standard 39, Financial Instruments: Recognition and Measurement, para. AG76, (NAV-1)

Page 14

Table 4 – HQ Bank’s Methods for Determining Fair Value in 2008 versus 200742

43. Table 4 above reveals that 97 percent of derivative assets and 95 percent of derivative liabilities were

valued at Level 3 in 2008 compared to 37 percent of derivative assets and 76 percent of derivative

liabilities in 2007. Thus, the disclosure that HQ Bank had adopted day 1 results either had no material

impact on the valuation of its derivatives portfolio given that no derivatives were valued under Level 1

methods and only 4 percent were valued under Level 2 methods (both of which require market evidence

to substantiate a day 1 results) or HQ Bank was wrongly recording day 1 results using Level 3 methods.

44. Fourth, HQ Bank’s new policy indicates that they did not consider the strike price of the underlying

security in determining the volatility parameter for instruments that only differed by the strike price. This

practice would tend to lead to wrong valuations because options are generally traded at different implied

volatilities depending on the strike price, where the implied volatility typically decreases with an

increasing strike price and vice versa.43 For example, the two charts below show the market implied

volatility for two of the top positions held by HQ Bank on 22 December 2008.

45. With respect to NOA3 put options expiring on 18 December 2009, the implied market volatility

decreases as the strike price increases as shown in Figure 1 below.

42 HQ AB 2008 Annual Report, Note 29, p. 68, (NAV-7) 43 “The volatility skew used by traders to price equity options (both those on individual stocks and those on stock indices) has the

general form….sometimes referred to as a volatility skew. The volatility decreases as the strike price increases. The volatility used to price a low-strike-price option (i.e., a deep-out-of-the-money put or a deep-in-the-money call) is significantly higher than that used to price a high-strike price option (i.e., a deep-in-the-money put or a deep-out-of-the-money call). Hull, John C., “Options, Futures, and Other Derivatives,” Fifth Edition. Prentice Hall. 2003, p. 334, (NAV-32)


Non-observable

Market Data


Non-observable

Market Data(Amounts in SEK millions) Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total

Assets

Derivatives - 964 572 1,536 - 72 1,995 2,067 Level as a % of Total 0% 63% 37% 100% 0% 3% 97% 100%Liabilities

Derivatives - 391 1,228 1,619 - 124 2,587 2,711 Level as a % of Total 0% 24% 76% 100% 0% 5% 95% 100%

2008

Instruments with Quoted

Market Prices

2007


Market Prices

Valuation Techniques Valuation Techniques

Page 15

Figure 1 – Market Implied Volatilities for NOA3 Put Options as of 22 December 200844

46. With respect to HMB call options expiring 20 March 2009, the implied market volatility also

decreases as the strike price increases as shown in Figure 2 below.

44 NOA3 Put Options Expiring 18 December 2009 per the Volatility Review as of 22 December 2008, (NAV-16)

40

43

45

48

50

53

55

58

60

63

65

4 6 8 10 12 14 16 18 20 22 24 26 28 30

Mar

ket

Impl

ied

Vol

atili

ty

Strike Price, SEK

NOA3 Put Option Expiring on 18 December 2009Market Price of NOA3 on 22 December 2008, EUR 11.14

Out-of-the-money In-the-money

Market Price = EUR 11.14

Page 16

Figure 2 – Market Implied Volatilities for HMB Call Options as of 22 December 200845

47. Thus, applying a single volatility metric regardless of strike price has the potential to misvalue the

instrument. Moreover, it cannot be overlooked that the size of the derivative portfolio increased by

approximately 50 percent in 2008 (see Table 25). These changes in the valuation policies, the resulting

use of Level 3 valuation techniques to value almost the entire portfolio, and the significant fall in global

equity markets in late 2008 should have necessitated a very close review of any difference between the

trading prices and prices calculated under Level 3 valuation techniques (particularly for large positions) in

order to ensure that the portfolio was fairly valued.

iii. The 2009 Financial Statements

48. My review of HQ AB’s 2009 financial statements indicates that there were two valuation policy

changes adopted in 2009 with regard to financial instruments.

45 HMB Call Options Expiring 20 March 2009 per the Volatility Review as of 22 December 2008, (NAV-16); The HMB

underlying security is Hennes & Mauritz AB which operates as H&M.

0

10

20

30

40

50

60

225 250 275 300 325 350 375 400

Mar

ket

Impl

ied

Vol

atili

ty

Strike Price, SEK

HMB Call Option Expiring on 20 March 2009Market Price of HMB on 22 December 2008, SEK 308

In-the-money

Out-of-the-money

Market Price = SEK 308

Page 17

49. First, the financial statements included more precise language explaining HQ AB’s definition of an

active market. HQ AB’s definition continued to consider HQ Bank’s position in a particular instrument

relative to the daily volume traded, but with more precise parameters.

“If HQ accounts for a significant proportion of the trade in a particular financial instrument this affects the opinion as to whether or not the market for that specific instrument is active.

HQ deems an active market to exist provided that more than 50 percent of HQ Bank’s position is sold per day, at least three such days occur during one week and at least three such weeks have occurred in the past 3-month period. The reason for considering this circumstance in assessing whether or not the market for a particular instrument is active is to eliminate the risk of individual traders, through unusual transactions, influencing the market price and, by extension, the company’s valuation in the statement of comprehensive income and the statement of financial position the level of activity in measurement is the ambition that the valuation should correspond to a representative pricing picture, and not be erroneously affected by minor transactions at unusual market prices.”46

50. Second, HQ AB deleted the “trading strategy” as a consideration in their Level 2 and Level 3

valuation techniques. Instead, the Bank described its valuation technique as relying only upon an

assumption that the volatility of an underlying security would revert to the mean.47 Mean reversion,

however, is still a concept pertaining to the future rather than the present. As such, I do not regard this

change as being meaningful from the policy adopted in 2008 which wrongly considered the trading

strategy in the valuation procedure.

“Theoretical valuation is based on accepted models for valuation of options. For American stock options the binomial model is normally used (put options) and Geske (call options), while Black & Scholes is used for European stock options and index options. The theoretical valuation of options is based on a trading strategy called mean reversion assumption, which assumes that the volatility of options in the long term will move towards a historical average. All option prices that deviate from the historical average are regarded as incorrectly price. This means that future volatility is estimated based on historical volatility rather than implicit volatility. The theoretical valuation assumes constant volatility, i.e. options with the same underlying instrument and expiration


Page 18

have the same volatility, irrespective of strike price. The valuation of options where there is an active market is based on implicit volatility. In cases where the market is not active and there is not sufficiently liquid trade in the options, the valuation is based on historical volatility.”48

51. Overall, HQ Bank ended up using more Level 2 valuation methodologies in 2009 versus 2008.

Also, these policy changes and/or new positions established resulted in the valuation of derivative

instruments under the Level 1 method. However, the portion of the portfolio valued under the Level 1

method represented just 2 percent of the entire derivative portfolio as shown in Table 5 below.

Table 5 – HQ Bank’s Methods for Determining Fair Value in 2009 versus 200849

52. Table 5 above reveals that HQ Bank reduced its reliance on Level 3 valuation techniques and

increased its reliance on Level 2 valuation techniques. However, the majority of derivative instruments

were still valued using non-observable market data. Additionally, the size of HQ Bank’s derivative

trading portfolio grew by 17 percent.

D. My Overall Opinion on the Methodologies HQ Bank Adopted to Value its Derivative Trading Portfolio

53. From my review of HQ AB’s financial statements, and in particular the descriptions of its valuation

policies, I draw the following three conclusions.

54. First, HQ Bank’s valuation policies wrongly incorporated its trading strategy or assumption that the

volatility in the traded derivative’s underlying security would revert to its historical average in the future.



Non-observable

Market Data


Non-observable

Market Data(Amounts in SEK millions) Level 1 Level 2 Level 3 Total Level 1 Level 2 Level 3 Total

Assets

Derivatives - 72 1,995 2,067 42 484 1,796 2,322 Level as a % of Total 0% 3% 97% 100% 2% 21% 77% 100%Liabilities

Derivatives - 124 2,587 2,711 65 1,104 2,089 3,258 Level as a % of Total 0% 5% 95% 100% 2% 34% 64% 100%


Market Prices

Valuation Techniques Instruments with Quoted

Market Prices

Valuation Techniques

2008 2009

Page 19

This is not a valid methodology to establish a current value for a derivative instrument. Instead, HQ Bank

adopted a valuation policy that valued some derivative positions at the price it hoped the instrument

would be valued at in the future rather than the present. Thus, the policy had the strong possibility of

misreporting the performance of the portfolio until such positions were ultimately closed.

55. Second, HQ Banks’s decision to consider the size of its market position in assessing whether or not

an active market was present had the ability to overstate the performance of its derivative portfolio unless

HQ Bank always valued asset positions lower than trading prices and liability positions higher than

trading prices. Large positions relative to the trading volume of an instrument are riskier positions and

HQ AB did not indicate whether or not HQ Bank adopted the more conservative valuation methodology.

56. Third, I consider that the proportion of derivative instruments valued by HQ Bank under Level 3

techniques to be a red flag, particularly in 2008. As a point of reference, I compared the proportion of

derivative positions valued under each level by HQ Bank against the proportion of derivatives valued

under each level by the four largest Banks in Sweden. Additionally, I have also included the statistics of

Carnegie Bank and two other European banks that have been clients of mine in the past few years.50 As

Table 6 below indicates, the percentage of derivatives in the Bank’s trading portfolio classified as Level 3

was extraordinarily high as compared to the other banks.

50 Carnegie Bank was included in my assessment of these Swedish banks because Carnegie Bank acquired HQ Bank as of 3

September 2010.

Page 20

Table 6 – 2009 Fair Value Methodology as a Percent of Total Derivatives51

57. In addition, I note that HQ AB did not report a reconciliation of the opening and closing balances for

the instruments valued under Level 3 using non-observable market data. This reconciliation would show

changes during the period attributable to gains and losses, purchases, sales, issues, transfers and

settlements. In contrast, all of the banks in Table 6 above reported this information. Figure 3 below is an

example of the disclosure made by Nordea regarding movements within its accounts due to purchases,

sales, issues and settlements, total gains and losses for the period recognized as a profit or loss, and

transfers out of Level 3.

51HQ AB 2009 Annual Report, p. 68, (NAV-8); Nordea 2009 Annual Report, p. 143, (NAV-9); SEB 2009 Annual Report, p.

102, (NAV-10); Handelsbanken 2009 Annual Report, p. 98, (NAV-11); Swedbank 2009 Annual Report, p. 102, (NAV-12); Carnegie 2009 Yearly Report, p. 40, (NAV-13); CSOB 2009 Annual Report, p. 104, (NAV-14); Istrokapital 2009 Annual Report, p. 46, (NAV-15)


Non-observable Market Data

Bank Level 1 Level 2 Level 3 Total

HQ Bank Assets 1.81% 20.84% 77.35% 100.00%Liabilities 2.00% 33.89% 64.12% 100.00%

Nordea Assets 0.79% 96.10% 3.10% 100.00%Liabilities 0.80% 96.07% 3.13% 100.00%

SEB Assets 34.97% 64.34% 0.69% 100.00%Liabilities 8.27% 90.80% 0.93% 100.00%

Handelsbanken Assets 3.06% 96.94% 0.00% 100.00%Liabilities 3.05% 96.95% 0.00% 100.00%

Swedbank Assets 4.85% 95.15% 0.00% 100.00%Liabilities 4.97% 94.91% 0.12% 100.00%

Carnegie Assets 27.72% 72.28% 0.00% 100.00%Liabilities 58.26% 41.74% 0.00% 100.00%

CSOB Assets 0.00% 100.00% 0.00% 100.00%Liabilities 0.00% 100.00% 0.00% 100.00%

Istrokapital Assets 61.53% 30.23% 8.24% 100.00%Liabilities 0.00% 100.00% 0.00% 100.00%

(Amounts in SEK millions) 2009 Fair Value Level as a % of Total Derivatives

Instruments with Quoted Market

Prices

Valuation Techniques Based on

Figure 3

58. Figu

valued un

as of 1 Ja

During th

million in

derivative

million in

instrumen

position o

financial

observabl

52 Nordea 2053 Settlemen54 Nordea 20

– Nordea 2

ure 3 above re

nder Level 3 t

anuary 2009

he year, Nord

n unrealized

es valued und

n derivative

nts Nordea va

of € 56 milli

statements to

le market data

009 Annual Rep

nts refer to offset

009 Annual Rep

2009 Disclos

econciles the

to the ending

Nordea had

dea recorded

profits for t

der Level 3 to

assets into L

alued under L

ion.54 The di

o evaluate in

a on the finan

port, p. 145, (NA

tting purchases a

port, p. 145, (NA

sure of Open

beginning b

balance of th

a net liability

on its incom

the derivative

otaling a liabi

Level 3. As

evel 3 went f

isclosure of t

detail the imp

ncial position

AV-9)

and sales of fina

AV-9)

ning and Cl

alance as of

hose instrume

y of € 141 m

me statement €

es valued un

ility of € 237

a result of t

from a net liab

the movemen

pact of the v

of a bank.

ancial instrument

losing Balan

1 January 20

ents as of 31

million of der

€ 219 million

nder Level 3

7 million.53 F

these movem

bility position

nts in Level

valuation of fi

ts presented on a

nces for Lev

009 for the in

December 20

rivatives valu

n in realized

3. In additio

Finally, Norde

ments the bala

n of € 141 mi

3 derivatives

financial instru

a net basis.

Pag

vel 352

nstruments N

009. For exa

ued under Le

profits and €

on, Nordea s

ea transferred

ance of deriv

illion to a net

s enables use

uments using

ge 21

Nordea

ample,

vel 3.

€ 164

settled

d € 51

vative

t asset

ers of

g non-

Page 22

59. In order to assess whether or not the valuation policies adopted by HQ Bank fairly represented the

performance of their derivative trading portfolio, a detailed examination of the trading portfolio is

necessary. In Section III which follows, I undertake this analysis.

III. My Examination and Review of HQ Bank’s Trading Portfolio

60. In this section, I describe the manner in which my examination and review of HQ Bank’s trading

portfolio was carried out along with my conclusions regarding HQ Bank’s valuation methods at various

points in time. In Section III.A, I discuss the data I received and used in my examination, as well as the

process I used to evaluate and analyze that data. In Section III.B, I discuss my evaluations of the trading

portfolio and HQ Bank’s valuation methods in 2007, 2008, and 2009. In Section III.C, I discuss my

conclusions regarding the Bank’s financial reporting of the trading portfolio between 2007 and 2009.

A. Overview of the Manner in Which My Examination and Review was Carried Out

61. The data I received and used in conducting my examination of HQ Bank’s trading portfolio and

valuation methods included: 1) periodically generated data files containing details on the trading portfolio

(“Volatility Reviews”), 2) daily generated data files containing details on the trading portfolio, 3) HQ

Bank trading files, 4) market data and trading statistics from the Eurex Exchange, and 5) market data and

trading statistics from the Nasdaq OMX Stockholm Exchange.55 I discuss each of these three sets of data

separately in the following 5 subsections and then outline the process I used to incorporate this data into

my examination in the 6th subsection.

i. Volatility Reviews

62. HQ Bank regularly produced a Microsoft Excel workbook containing financial information on HQ

Bank’s proprietary trading portfolio. These workbooks were described by HQ Bank as Volatility

Reviews because the data was shared with the risk management department and the CEO to evaluate the

positions taken by the traders and, hence, by the Bank.56 I was provided with 41 of these Volatility

Reviews at various points in time between May 2007 and May 2010, as well as Daily Reviews of the

55 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); HQ Bank Daily Volatility Reviews, (NAV-17); HQ

AB Trading Files, (NAV-18); Eurex Exchange Price Statistics for Options, May 2007 through May 2010, (NAV-19); Nasdaq OMX Stockholm Exchange Price Statistics for Options, May 2007 through May 2010, (NAV-20). I obtained the market data directly from the Nasdaq OMX or Eurex exchanges except for the last, bid and ask prices for the Eurex which I obtained from Bloomberg. Bloomberg provided the Eurex historical last, bid and ask prices data in a format that was easier to use than the data obtained directly from Eurex. Bloomberg, Historical Price Statistics for DAX and NOA3 Securities, (NAV-21)

56 Rules and Procedures for Trading Memorandum issued by HQ Bank’s Board of Directors, 13 December 2000, (NAV-4)

Page 23

trading portfolio between February 2009 and June 2010.57 I first discuss the 41 Volatility Reviews and

then the Daily Reviews.

63. The Volatility Reviews provide a historical summary of the positions of the trades HQ Bank had

established to attempt to generate profits from its proprietary trading activity. I understand these

Volatility Reviews were used to calculate the profits and losses (both realized and unrealized) of the

trading portfolio that were recognized on HQ AB’s income statement, as well as the fair value of the

positions in the trading portfolio that were recognized as assets or liabilities on HQ AB's Balance Sheet.

The positions in the reviews included equity stocks traded in the spot market as well as calls, puts,

futures, forwards, and convertibles traded in the derivatives markets. Also, a significant portion of the

financial instruments traded included market indices for the Frankfurt Stock Exchange (“DAX” index) or

the Stockholm OMX market (“OMXS30” index) rather than for individual companies.58 The fields

provided in each of the reviews are largely consistent across the 41 Volatility Reviews. The data in each,

however, naturally differs due to the passage of time as the Bank entered new positions and exited old

positions throughout the relevant time period. Moreover, all positions were impacted by movements in

their respective markets. In Table 7 below, I include a description of the data fields in the Volatility

Reviews. As an example, I also include the data values for a call position taken by the Bank. I discuss in

more detail the most relevant fields to my analysis in the following paragraphs.

57 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); HQ Bank Daily Volatility Reviews, (NAV-17) 58 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16)

Page 24

Table 7 – Description of Relevant Fields to my Review in the Volatility Reviews59

59 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); See Appendix 3 for a detailed list of the available

fields by Volatility Review date. The position presented in Table 7 is per of the 30 December 2009 volatility review.

Field Description of Field and/or Formula ExampleDescriptive Fields

Contract Name of the instrument ODAX F6200

CryCurrency of the instrument (The exchange rates used to calculate some fields in the file are not provided.)

EUR

Underlying Underlying index or stock for derivative position. ODAX Market Market in which the position trades. Eurex

Contract kindFor traded instruments: Call, Put, Future, Forward, Spot, Interim SpotFor totals fields: Balance, Carry, Cash

Call

Strike Strike price for derivative positions 6,200 Exec. Option type (European or American) EuropeanExpiration Date Expiration Date of derivative position 6/18/2010Mult. Multiplier for derivative positions 5 Other descriptive fields ISIN-code, Feedcode, Act.FR

Fields on Investment

PositionsNumber of shares held by the Bank (liability positions are negative and asset positions are positive)

(60,000)

InvestedCumulative value of the investment at actual purchase price (Shares Purchased or Sold x Price of Purchase or Sale)

(646,542,867)

Price FieldsBase Quoted market price of underlying instrument for derivative positions 5,971 Price Quoted market price of the instrument 265.00

Implied VolatilityVolatility for derivative positions based on quoted market prices

22.25

MV(market)Actual Market Value = Position x Contract Multiplier x Market Price x Exchange Rate

(816,659,775)

Actual Volatility (Theoretical Volatility)

Theoretical volatility for derivative positions calculated by HQ Bank 20.00

ModelModel used to value the theoretical price of the derivative positions (Binomial, Default, Geske)

Default

Th.value Price derived from theoretical volatility 229.10 MV(theor) Position x Contract Multiplier x Theoretical Price x Exchange Rate (705,888,449)

MV(mkt/th)Value used by Bank to value the Edge either based on a quoted market price or the theoretical price calculated by the Bank

(816,659,775)

Edge [Edge th] MV(theor) - MV(mkt/th) 110,771,326 Res(theor) Theoretical Result = MV(theor) - Invested (59,345,583) Real.Res Theoretical Result for positions that have been closed as of a certain date - Unreal.Res(th) Theoretical Result for positions that are still open as of a certain date (59,345,583)

Other price fieldsVega, Delta, Cash Delta, Gamma, Vol. Theta, Theta, Rho, C. Delta (These fields represent the sensitivity of the price of the derivative to the movement of various underlying parameters.)

Page 25

64. The theoretical market value [MV(theor)] represents the value of a position based on a theoretical

price determined by the Bank (i.e. a Level 2 or 3 valuation technique). The theoretical market value is

calculated using other data elements in the Volatility Reviews such as the position [Position] (e.g.,

number of contracts or shares), theoretical price [Th.value], contract multiplier [Mult.], and data elements

not captured in the Volatility Reviews such as currency exchange rates when the underlying security is

not measured in SEK.60

65. The theoretical market value is also an input for calculated values in other fields in the Volatility

Reviews. For example, the difference between the theoretical market value [MV(theor)] and the amount

invested [Invested] for a particular position is the theoretical gain or loss [Res(theor)]. This is the gain or

loss recorded in the Bank’s financial statements. The theoretical gain or loss [Res(theor)] is then split

between realized gains [Real.Res] if a certain portion of a position has been closed out and unrealized

gains [Unreal.Res(th)] for the position that remains open.

66. The theoretical market value [MV(theor)] also represents the carrying value of the position on the

balance sheet of the Bank. 61 From my review of the Volatility Reviews closest to the year-end, I found

that there was a very small difference between the theoretical values reported on the Volatility Reviews

and the Bank’s audited balance sheets. For example, in Table 8 below I compared the total assets and

liabilities reported in the Volatility Reviews on 18 December 2007, 22 December 2008, and 30 December

2009 with the year-end values reported on the audited balance sheets as of 31 December 2007, 31

December 2008, and 31 December 2009 respectively.

60 Options contracts are based on a specified number of underlying securities. For example, in the case of ODAX F6200 calls, it

is 5 shares per contract. See Table 7 above. 61 Rules of Procedure for Trading Memorandum issued by HQ Bank’s Board of Directors, 13 December 2000, p 3, (NAV-4); HQ

AB 2008 Annual Report, Note 1, p. 47, (NAV-7)

Page 26

Table 8 – Comparison of Asset Values between Volatility Reviews and HQ Group Audited Balance Sheets62

67. The balances in Table 8 above for both the volatility reviews and the balance sheet indicate to me

that the Volatility Reviews represent reliable data to assess the Bank’s valuation practices in respect of

its trading positions. Accordingly, I consider that the Volatility Reviews represent reliable data to assess

the Bank’s valuation practices in respect of its trading positions.

68. Like the theoretical market value [MV(theor)], the market value field [MV(market)] is calculated

using other data elements in the Volatility Reviews such as the position [Position] (e.g., number of

contracts or shares), price [Price], contract multiplier [Mult.], and data elements not captured in the

62 HQ Bank Volatility Reviews as of 18 December 2007, 22 December 2008, and 30 December 2009, (NAV-17); HQ AB 2007

Annual Report, p. 68, (NAV-5); HQ AB 2008 Annual Report, p. 65, (NAV-7); HQ AB 2009 Annual Report, p. 67, (NAV-8)

(Amounts in SEK millions)

Theoretical Value on Volatility Reviews

Reported Value on

Balance Sheet

Reported Balance Sheet

Value Less Theoretical

Value

Reported Balance Sheet

Value Less Theoretical Value (% )

Date of Analysis 18-Dec-07 31-Dec-07Call Assets 412 Put Assets 1,190 Total 1,602 1,536 (66) -4%

Call Liabilities (811)Put Liabilities (793)Total (1,604) (1,619) (15) 1%

22-Dec-08 31-Dec-08Call Assets 482 Put Assets 1,564 Total 2,046 2,057 11 1%

Call Liabilities (492)Put Liabilities (2,106)Total (2,598) (2,694) (96) 4%

30-Dec-09 31-Dec-09Call Assets 2,190 Put Assets 126 Total 2,316 2,322 6 0%

Call Liabilities (2,960)Put Liabilities (296)Total (3,256) (3,256) 0.14 0%

Page 27

Volatility Reviews such as currency exchange rates when the underlying security is not measured in

SEK.63 Based on my analysis of the Volatility Reviews, the price [Price] appears to correspond to the last

trade of the instrument in the relevant market (i.e., Nasdaq OMX Stockholm or the Eurex).

69. Accordingly, the difference between theoretical market value [MV(theor)] and market value

[MV(market)] is that market value [MV(market)] is calculated using a quoted trading price (i.e. a

potential Level 1 valuation if the market from which the price [Price] is derived is an active market) while

the theoretical value [MV(theor)] is calculated using a Level 2 or 3 valuation technique.

70. As mentioned, the market price [Price] appears to correspond with the price of the last trade of the

instrument in the relevant market. In some Volatility Reviews, however, I noted that the market price

[Price] was not populated even though there was a value available at the time to populate the field. I also

noted that in some cases, although the market value [MV(market)] field was populated, the market price

[Price] field was not. I discuss this issue and how I have dealt with it later in this report.

71. The Volatility Reviews contained another market value field [MV(mkt/th)]. This field was equal to

the previously discussed market value field [MV(market)] unless there was no data populated in the

market value field [MV(market)]. If there was no data populated in the market value field [MV(market)],

the [MV(mkt/th)] field was populated with the value from the theoretical value field [MV(theor)].

72. The [MV(mkt/th)] field was used by the Bank to calculate the difference between the theoretical

market value [MV(theor)] and the market value [MV(mkt/th)]. This difference is captured in a field

called the edge [Edge th]. However, in some cases, I noted that the edge field [Edge th] was not

populated in the Volatility Reviews even though it could have been populated. Also, as just noted, the

[MV(mkt/th)] field in the Volatility reviews was often populated with the theoretical market value field

[MV(theor)] because the market value field [MV(market)] was not populated. I discuss this issue and how

I have dealt with it later in this report.

73. The majority of the 41 Volatility Reviews provide an assessment of all of the Bank’s spot and

derivative positions. Ten of them, however, do not include any information related to the Bank’s spot

63 Options contracts are based on a specified number of underlying securities. For example, in the case of ODAX F6200 calls, it

is 5 shares per contract.

Page 28

positions on the respective Volatility Review dates.64 As such, my analysis conducted on the Bank’s

positions on those 10 dates only pertains to the Bank’s derivative positions.

ii. Daily Reviews

74. With regards to the Daily Reviews, I received 19 Microsoft Excel files corresponding to the months

of February 2009 to June 2010.65 These files contain reviews similar to the 41 Volatility Reviews, but

show data for each trading day rather than once or twice a month like the Volatility Reviews. The Daily

Reviews generally provide a detailed representation of the Bank’s derivative positions on the DAX and

OMXS30, but a considerably more limited representation of the Bank’s other spot and derivative

positions. The Bank’s other positions are largely defined as a single “total” line item with no detail as to

the underlying positions included in that total. The fields in these Daily Reviews are largely consistent

with the fields contained in the Volatility Reviews. Five of the Daily Reviews were not included in my

evaluation as they only provide a minimal assessment of the portfolio on those days.66

iii. HQ Bank Trading Files

75. In addition to the Volatility Reviews and Daily Reviews, I also received two files with trading data

for the options and futures positions in part of HQ Bank’s trading portfolio. The files are divided into

different worksheets, with data during the period 2007-2010, as of six different dates: 1) 8 August 2008,

2) 1 November 2008, 3) 1 April 2009, 4) 1 September 2009, 5) 2 February 2010, and 6) 30 June 2010.67

Each worksheet in the two files contains a field labeled “Portfolio.” Every worksheet within one of the

files is populated with “FC,” i.e., Fredrik Crafoord. The other file contains a numeric value,

predominately “2.” I have been informed that the two files contain trades made from the trading portfolio

for Fredrik Crafoord.

64 See Appendix 3 for a list of the Volatility Reviews that do not contain spot data. 65 HQ Bank Daily Volatility Reviews, (NAV-17) 66 See Appendix 3 for additional detail. 67 One of the files provides trades as of 8 August 2008, 1 November 2008, and 1 April 2009 and the other includes trades as of 1

April 2009, 1 September 2009, 2 February 2010, and 30 June 2010. While both of the files provide trades as of 1 April 2009, there is no overlap across the two files as of this date. Duplicate trades, however, do appear within the files. For example, a trade made in the first quarter of 2009 would appear on the worksheet for 1 April 2009, while that same trade may appear again on the worksheet labeled 1 September 2009. Almost 60 percent of the trades in these files were created in 2009. A total of 326,665 trades are contained in these two files, of which 44,513 are duplicates of the kind described. Of the remaining trades, 15 percent were made in 2008 and 27 percent in 2010. Only 38 trades were made in 2007.

Page 29

76. These files present the underlying derivative instruments in the Bank’s portfolio that was traded, the

date and time the instrument was traded, whether the instrument was bought or sold, the volume bought

or sold, the market on which the instrument was traded, the expiration date of the instrument, and the

price at which the instrument was traded.68 The change in some positions for a given instrument can be

tracked with these files more frequently than with the Volatility Reviews which only present the trading

portfolio once a or twice a month. However, the trading files do not contain any detail of the Bank’s

theoretical valuations of the positions.69

iv. Data and Trading Statistics from the Eurex Exchange

77. I incorporated data and statistics from the Eurex Exchange into my evaluation and analyses.70 This

data includes pricing and trading volumes for all options traded on the exchange. I received some data

from Counsel and the rest I downloaded directly from the Eurex website or Bloomberg.71 The files

received or downloaded from the Eurex are monthly files that include aggregated exchange data for the

entire month. Table 9 below shows a sample of Eurex data for one position – in this case a call option on

the DAX with a strike price of €5,800 and an expiration date of March 2010.

Table 9 – Sample of Monthly Trading Data from the Eurex Exchange – Call Option on the ODAX with a Strike Price of €5,800 and Expiration in March 201072

68 HQ AB Trading Files, (NAV-18)

69 HQ AB Trading Files, (NAV-18) 70 Eurex Exchange Price Statistics for Options, May 2007 through May 2010, (NAV-19) 71 I received Eurex Exchange data from Counsel for October, November, and December 2009. For the remaining periods

covered by the Volatility Reviews, I downloaded exchange data for each month directly from the Eurex website. Eurex Exchange Price Statistics for Options, May 2007 through May 2010, (NAV-19); Bloomberg, Historical Price Statistics for DAX and NOA3 Securities, (NAV-21)

72 Eurex Exchange Price Statistics for Options, May 2007 through May 2010, (NAV-19)

Date Month Year Opening Highest Lowest Settlement Volume

12/1/2009 ODAX 3 2010 5,800 275.00 302.90 275.00 302.00 6,189 51,261 12/2/2009 ODAX 3 2010 5,800 302.40 312.20 297.80 301.00 2,138 49,730 12/3/2009 ODAX 3 2010 5,800 333.00 336.00 299.00 298.00 61 49,771 12/4/2009 ODAX 3 2010 5,800 280.40 342.60 279.30 317.10 380 49,777 …

12/23/2009 ODAX 3 2010 5,800 370.00 378.00 345.90 352.30 629 43,385 12/28/2009 ODAX 3 2010 5,800 381.00 381.00 374.50 378.20 105 43,284 12/29/2009 ODAX 3 2010 5,800 381.00 385.00 381.00 372.80 12 43,280 12/30/2009 ODAX 3 2010 5,800 348.00 348.00 348.00 340.30 10,004 53,280

Open InterestProduct ID

Expiration Price InformationExercise Price

Page 30

78. As shown in Table 9 above, the exchange provides various price statistics including the opening,

highest, lowest, and settlement prices as well as trading volume and open interest for a given instrument.73

The settlement prices are utilized by the exchange to determine the margin requirements.74 From

Bloomberg, I was able to download bid and ask prices along with last price, which corresponds to the

settlement price in the data downloaded directly from the Eurex.

v. Data and Trading Statistics from Nasdaq OMX Exchange

79. In addition to data from the Eurex Exchange, I also incorporated options data and statistics from the

Nasdaq OMX Exchange. Counsel provided daily price lists for all positions on the exchange from 1

January 2007 through 30 June 2010.75 Similar to the data from the Eurex, this data provides volume,

open interest, and pricing information for all instruments that trade on the Nasdaq OMX. Included in the

pricing information are closing bids and asks, closing highs and lows, as well as the closing prices. The

closing prices correspond to the price of the last trade of the relevant instrument.76

vi. Process Used to Incorporate External Data into the Volatility Reviews

80. The primary purpose of analyzing the trading portfolio is to assess the impact of the Bank’s

valuation policies on the reported value of its trading positions and to evaluate the Bank’s valuation

methods. Thus, the most relevant fields in the Volatility Reviews and Daily Reviews for my analysis are

the market value [MV(market)], theoretical market value [MV(theor)], and the edge [Edge th]. As I have

discussed in the prior subsections, market prices [Price] and market values [MV(market)] were often

missing in respect of a number of positions. Thus, the Volatility Reviews often do not present a complete

picture of the difference between the market value [MV(market)] and the theoretical market value

[MV(theor)]. This difference, which is captured in the edge [Edge th] (but not always accurately) is a

gauge by which one can assess whether or not the valuation technique adopted by the Bank differed

materially from the market value. In essence, it is a gauge to assess the impact of the Bank choosing to

73 I similarly incorporated pricing statistics for underlying securities that trade on the Eurex Exchange from the Bloomberg

service. Because the files from the Eurex Exchange did not include bid and ask prices, I used the Bloomberg service to obtain those prices for the relevant securities. Bloomberg, Historical Price Statistics for DAX and NOA3 Securities, (NAV-21)

74 Eurex Exchange, Glossary: Definition of Daily Settlement Price, (NAV-29); Eurex Exchange, Clearing: Risk Based Margining, (NAV-30)

75 Nasdaq OMX Stockholm Exchange Price Statistics for Options, May 2007 through May 2010, (NAV-20) 76 If there is no volume traded for an instrument on a specific date, the closing price field is not populated. Nasdaq OMX, Nasdaq

OMX Nordic Market Model 2.6, 22 August 2011, p. 85, (NAV-22)

Page 31

adopt its own subjective valuation rather than designating the instrument as trading in an active market

and relying on the trading price for valuation purposes.

81. To properly evaluate the market values, theoretical market values, and any misvaluation, I imported

all of the data sets previously discussed (the Volatility Reviews, Daily Reviews, Trading files, and market

data from the Eurex and Nasdaq OMX exchanges) into Microsoft Access to create a database in which I

could efficiently analyze the data. I then sought to confirm the information in the market value fields in

the Volatility Reviews with the Eurex and Nasdaq OMX data and fill in missing information. I was able

to confirm many market value calculations in the Volatility Reviews using closing or last prices.77 Using

bid and ask prices, I would often get a different result than the Bank which would generate a higher edge.

While IAS 39 expresses a preference for bid and ask prices over recent transaction prices, I adopted

settlement prices in preference to bid and ask prices. Settlement prices are utilized by the exchanges to

determine the margin requirements and are effectively the cash profits or losses recognized by the

exchange for each position.78 The objective of the exchange regulator is to establish a price so that

neither party to a position has counterparty risk. However, I noted that the Nasdaq OMX does not often

report the settlement price.79 Thus, for OMX positions I relied on the last trade price (i.e. the closing

price reported by the Nasdaq OMX).80 Using settlement or closing prices rather than ask or bid prices

resulted in a more conservative calculation of the edge.81 If my market value calculation differed from

the Bank’s market value calculation, I relied upon my market value calculation (regardless of whether my

calculation was higher or lower than the Bank’s). If the Eurex or Nasdaq OMX data did not allow me to

calculate a market value on a particular Volatility Review date, I relied upon the Bank’s calculation. If

the Volatility Review did not contain a market value and I could calculate one, I relied on my

77 Overall, I was able to match 95 percent of the individual put or call contracts held by the Bank between the Volatility Review

files and the EUREX and OMX data files. For 5 percent of the contracts, I was not able to find a match in the market data due to a small number of inconsistencies in the naming conventions of the positions and/or because the underlying security did not trade on the Nasdaq OMX or Eurex exchanges.

78 Eurex Exchange, Glossary: Definition of Daily Settlement Price, (NAV-29); Eurex Exchange, Clearing: Risk Based Margining, (NAV-30)

79 Nasdaq OMX Stockholm Exchange, Price Statistics for Options, (NAV-20); Navigant Edge Database, (NAV-23) 80 NASDAQ OMX Nordic Market Model 2.6, 22 August 2011, p. 85, (NAV-22) 81 Navigant Edge Database, (NAV-23)

Page 32

calculation.82 My updated prices for the Bank’s put and call derivative positions are attached to this

report as Exhibit NAV-23.

82. More specifically, with respect to Eurex Exchange data, for asset positions I used (in order of

preference), 1) settlement price 2) bid price, or 3) ask price for my market value calculation. For liability

positions I used (in order of preference), 1) settlement price, 2) ask price, or 3) bid price. With respect to

Nasdaq OMX data, for asset positions I used (in order of preference), 1) closing price 2) bid price, 3) an

average of the high and low prices, or 4) ask price. For liability positions I used (in order of preference),

1) closing price, 2) ask price, 3) an average of the high and low prices, or 4) bid price.83 Figure 4 below

presents the decision rules I used to determine the market prices.

82 See Appendix 2 for the fields that were populated for each Volatility Review. I rely on the Bank’s market price for 1,189 of

the 37,590 individual put and call contracts. This amounts to approximately 3 percent (3.2%) of the total number of contracts. The 1,189 contracts relate to positions for which I was not able to find a match in the market data due to a small number of inconsistencies in the naming conventions of the positions and/or because the underlying security did not trade on the Nasdaq OMX or Eurex exchanges. The magnitude of the edge related to the 1,189 contracts is less than 3 percent (2.42%) of the total Navigant Edge in absolute terms across all of the 41 volatility reviews.

83 The Eurex data did not provide the average of the high and low prices, only the data from the Nasdaq OMX did.

Figure 4

83. In ga

price, but

[Price] fro

price in ei

the Bank’

84 At each y

a lack of qrealistic mcomparedhave accebased on t

4 – Decision

athering this

t the volatility

om the volati

ither the OMX

s theoretical m

year-end I have mquoted market pr

market price. Bad those prices to qpted HQ Bank’sthe number of co

Rules for In

information,

y reviews did

ility reviews a

X data, the Eu

market price

made an overall rrices, to assess w

ased on my reviequoted prices in s theoretical pricontracts).

ncorporatin

I noted a few

d have a mark

as my market

urex data, or

as my market

review of the powhether there areew, where I made

similar instrumece for the relevan

ng Eurex an

w instances w

ket price [Pri

t price. In ca

a market pric

t price.84 Thu

ositions where I he any significante a random checents, I could notnt positions (whi

nd Nasdaq O

where I was n

ce]. In those

ases where I

ce [Price] in th

us, in these sit

have accepted Ht discrepancies bck of a number ot identify any sigich corresponds

OMX Mark

not able to fin

e cases, I use

could not fin

the volatility r

tuations there

HQ Bank’s theorbetween the theoof positions basegnificant discrepto less than 2 pe

Pag

ket Prices

nd a quoted m

ed the market

nd a quoted m

review files, I

e is no edge.

etical price, becaoretical price andd on size and

pancies and, thusercent of the port

ge 33

market

t price

market

I used

ause of d a

s, I tfolio

Page 34

84. I refer to the result of this analysis as the Navigant Edge. Where I reference an Edge amount

calculated using my updated market prices, I identify it as the Navigant Edge. Where I reference an Edge

amount calculated by HQ Bank, I identify it as the HQ Bank Edge. Where the same conclusion can be

made from both the Bank’s Edge and my calculated Navigant Edge, I identify it as the Edge.

B. Evaluation of the Trading Portfolio and HQ Bank’s Valuation Methods between 2007 and 2010

85. As previously discussed in Section II above and as disclosed in HQ AB’s financial statements, I

noted that the Bank largely relied upon Level 2 or Level 3 valuation methods to value the derivatives in

its trading portfolio. As such, the Bank’s valuations often resulted in a value different from the trading

price for securities that the Bank deemed were not trading in an active market. This difference was

captured in the Edge by the Bank, but not consistently. For this reason, I analyzed the Edge as calculated

using my updated market prices to further examine the Bank’s put and call options in more detail.

86. As shown in Figure 5 below, the Navigant Edge on 24 May 2007 (the earliest Volatility Review

available) was approximately SEK 200 million. Between May 2007 and July 2009, the Navigant Edge

fluctuated between approximately SEK 100 million and SEK 440 million. However, by 25 August 2009,

the Navigant Edge grew to SEK 626 million, nearly double the previous Navigant Edge of SEK 315

million on 28 July 2009. I note the HQ Bank Edge similarly increased from SEK 399 million to SEK 527

million. After August 2009 (with the exception of the 30 December 2009 Volatility Review) the

Navigant Edge remained within the range of SEK 600 million to SEK 900 million.

Figure 5

87. Giv

Bank’s pr

derivative

(“ERICB”

85 Navigant

5 – Evolution

ven the signif

roprietary trad

e positions the

”) shares, and

Edge Database,

n of HQ Ba

ficant increase

ding portfolio

e Bank took o

d Nokia (“NO

(NAV-23)

nk Edge an

e in the Edge

o, I discovere

on the OMXS

OA3”) shares a

nd Navigant

, I sought to i

ed that the va

S30 index, the

as shown in F

Edge for P

identify its so

ast majority o

e DAX index

Figure 6 below

Put and Call

ource. Drillin

of the Edge c

x, Ericcson Te

w.

Pag

l Options85

ng down with

can be attribu

elephone Com

ge 35

hin the

uted to

mpany

Page 36

Figure 6 – Navigant Edge for Put and Call Options by Underlying Security86

88. As Figure 6 above reveals, the Edge was originally concentrated in derivative positions on the

OMXS30 index (along with derivative positions in Ericsson and Nokia shares). However, in December

2008, the Edge became dominated by derivative positions on the DAX index. The fact that the largest

Edge values are attributable to options on the OMXS30 and DAX indices is surprising considering that

the options in these indices are likely to have the most liquidity as compared to options in individual

securities. Indeed, I would expect that many analysts would consider options trading on the DAX index

to be active markets deserving of a Level 1 rather than a Level 2 or 3 valuation. However, the Bank

valued a majority of these positions as Levels 2 or 3. Even under a Level 2 or 3 valuation, I would have

expected the valuation to be close to the market value. As such, the size of the difference is alarming. To

understand how the Edge was created further investigation and analysis is required.

86 Navigant Edge Database, (NAV-23)

-400

-200

0

200

400

600

800

1000A

mou

nts

in S

EK

mil

lion

s

ERICB NOA3 ODAX OMXS30 Other

Page 37

i. Investigation of Positions and Valuations Creating the Edge

89. My more detailed evaluation of the Edge led to the following two observations.

90. First, Figure 6 above reveals there was a significantly negative Edge pertaining to an OMXS30

position in late December 2009. I investigated this apparent anomaly and I sourced the negative Edge to

a Volatility Review prepared on 30 December 2009 and to two positions on the OMXS30: 1) a liability

position in 11,500 call option contracts with a strike price of SEK 660 and expiration date of 22 January

2010, and 2) a liability position in 6,010 call option contracts with a strike price of SEK 700 and

expiration date of 22 January 2010. The negative Navigant Edge resulting from these two positions

totaled SEK 365 million.87

91. I compiled a historical summary of the Volatility Reviews associated with these two positions and

present my findings in Table 10 below.

87 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16)

Page 38

Table 10 –Volatility Reviews for OMXS30 Calls with a Strike Price of SEK 660 and SEK 700 and Expiration of 22 January 201088


Strike Price of SEK 660

Volatility Review Position

Price of OMXS30

Navigant MV(mkt/th) MV(theor)

Navigant MV(market)

Navigant Edge

Market Price

Theoretical Price

22-Dec-08 -6,500 659.00 (55,412,500) (44,487,520) (55,412,500) 10,924,980 85.25 68.4427-Jan-09 -6,500 611.50 (40,950,000) (33,219,740) (40,950,000) 7,730,260 63.00 51.1123-Feb-09 -5,500 632.75 (34,375,000) (30,515,961) (34,375,000) 3,859,039 62.50 55.4825-Mar-09 -11,500 637.25 (94,012,500) (54,353,174) (94,012,500) 39,659,326 81.75 47.2627-Apr-09 -11,500 756.75 (162,030,823) (162,030,823) - - - 140.9027-May-09 -11,500 772.50 (178,825,000) (170,564,739) (178,825,000) 8,260,261 155.50 148.3226-Jun-09 -11,500 788.50 (181,126,652) (181,126,652) - - - 157.5028-Jul-09 -11,500 853.50 (262,124,468) (262,124,468) - - - 227.9325-Aug-09 -11,500 913.75 (304,599,793) (304,599,793) - - - 264.8728-Sep-09 -11,500 893.25 (290,656,271) (290,656,271) - - - 252.7421-Oct-09 -11,500 930.25 (337,942,737) (337,942,737) - - - 293.8627-Nov-09 -11,500 944.50 (327,911,733) (327,911,733) - - - 285.1429-Dec-09 -11,500 968.00 (354,141,785) (354,141,785) - - - 307.95

30-Dec-09 -11,500 951.86 (86,250,000) (335,586,134) (86,250,000) (249,336,134) 75.00 291.81


Volatility Review Position

Price of OMXS30

Navigant MV(mkt/th) MV(theor)

Navigant MV(market)

Navigant Edge

Market Price

Theoretical Price

25-Nov-08 -10 643.50 (82,250) (81,095) (82,250) 1,155 82.25 81.1022-Dec-08 -10 659.00 (67,000) (49,680) (67,000) 17,320 67.00 49.6827-Jan-09 -10 611.50 (35,332) (35,332) - - - 35.3323-Feb-09 -4,510 632.75 (17,270,986) (17,270,986) - - - 38.2925-Mar-09 -6,010 637.25 (38,464,000) (18,860,562) (38,464,000) 19,603,438 64.00 31.3827-Apr-09 -6,010 756.75 (65,776,613) (65,776,613) - - - 109.4527-May-09 -6,010 772.50 (76,477,250) (69,353,776) (76,477,250) 7,123,474 127.25 115.4026-Jun-09 -6,010 788.50 (75,425,500) (73,165,103) (75,425,500) 2,260,397 125.50 121.7428-Jul-09 -6,010 853.50 (113,504,736) (113,504,736) - - - 188.8625-Aug-09 -6,010 913.75 (135,335,670) (135,335,670) - - - 225.1828-Sep-09 -6,010 893.25 (127,959,335) (127,959,335) - - - 212.9121-Oct-09 -6,010 930.25 (152,604,420) (152,604,420) - - - 253.9227-Nov-09 -6,010 944.50 (147,338,932) (147,338,932) - - - 245.1629-Dec-09 -6,010 968.00 (161,041,527) (161,041,527) - - - 267.96

30-Dec-09 -6,010 951.86 (36,060,000) (151,344,018) (36,060,000) (115,284,018) 60.00 251.82

*MV(mkt/th), MV(theor), MV(market), and Invested amounts are in SEK.

Page 39

92. Table 10 above reveals that the Bank often did not report the market value for these two contracts in

the Volatility Reviews. However, as of 30 December 2009, the Bank reported a market value of SEK 75

and SEK 60 for the contracts with strike prices of SEK 660 and SEK 700, respectively. In reviewing the

underlying value of the OMXS30 index throughout 2009, I noted that the index rose from SEK 659 on 22

December 2008 to SEK 952 on 30 December 2009.89 This significant increase in the OMXS30 should

have caused the price of the call options to rise considerably since an asset position in these contracts

would have been deep in the money. I noted that the theoretical prices recorded by the Bank did rise

sharply during this time, essentially reaching the difference between the OMXS30 index and the strike

price of each contract of SEK 291.81 for the contract with a SEK 660 strike price and SEK 251.82 for the

contract with a SEK 700 strike price as of 30 December 2009. However, these prices differed

significantly from the alleged market prices of SEK 75 and SEK 60 found in the Volatility Reviews.

Indeed, those prices are nonsensical.

93. I checked the historical OMXS30 trading data for these two contracts to see if I could obtain a more

accurate market price. The historical trading data strangely confirmed both prices. However, I noted that

the trading volume was very low. I then evaluated the HQ trading data to see if the Bank had placed any

orders for these contracts on 30 December 2009 and discovered that the Bank was indeed the source of

the price. As shown in Table 11 below, an inactive order was placed for both contracts after trading had

closed for the day. As mentioned in the previous paragraph, given the price of the underlying index and

the strike prices of the options, the alleged market prices of SEK 75 and SEK 60 are nonsensical.

89 Bloomberg, Historical Market Prices for the DAX, (NAV-21)

Page 40

Table 11 – Trade Data for OMXS30 Call Strike SEK 660 and SEK 700 Expiration 22 Jan 201090

94. Thus, while the Bank had properly recorded that its liability based on the theoretical market value

(reflected in the accounts) was increasing under these contracts due to the liability position taken, it

strangely recorded its liability on a market basis (only used in the volatility reviews) to be much lower.

This artificial market price information did not affect the Bank’s reported financial results, but did have

the effect of understating the overall Edge in the trading portfolio.

95. I note that in 2010, the Bank removed the artificial market price in its Daily Volatility Reviews, thus

substantially increasing its overall Edge as shown in Table 12 below.

90 HQ AB Trading Files, (NAV-18)


Created (d)

Type of Trade

Bought / Sold Volume

Cumulative Volume

Trade Price Traded Created (t) Comment

04-Dec-08 Trade S (6,500) (6,500) 94.75 2:10:07 PM 2:10:14 PM30-Jan-09 Trade B 1,000 (5,500) 63.50 11:03:43 AM 11:03:46 AM24-Mar-09 Trade S (6,000) (11,500) 78.75 12:54:05 PM 12:54:10 PM28-Dec-09 Inactive order B 10 (11,490) 100.00 3:27:03 PM

30-Dec-09 Inactive order B 10 (11,480) 75.00 5:18:52 PM

25-Jan-10 Trade B 11,500 20 291.36 7:58:46 AM 7:58:47 AM25-Jan-10 Trade B 11,500 11,520 291.36 7:58:46 AM 7:58:47 AM Expiration (closed, cash settlement)


Created (d)

Type of Trade


Cumulative Volume

Trade Price Traded Created (t) Comment

03-Nov-08 Trade S (10) (10) 86.50 2:57:27 PM 2:57:32 PM12-Feb-09 Trade S (4,500) (4,510) 60.00 3:12:37 PM 3:12:42 PM13-Mar-09 Trade S (1,500) (6,010) 61.50 3:44:36 PM 3:44:45 PM

30-Dec-09 Inactive order B 10 (6,000) 60.00 5:19:48 PM

25-Jan-10 Trade B 6,010 10 251.36 7:58:47 AM 7:58:48 AM Expiration (closed, cash settlement)25-Jan-10 Trade B 6,010 6,020 251.36 7:58:47 AM 7:58:48 AM

Page 41

Table 12 – Daily Volatility Reviews for OMXS30 Calls with Strike Prices of SEK 660 and SEK 700 and Expiration of 22 January 201091

96. Removing these artificial market prices from the 30 December 2009 Volatility Review increases the

Navigant Edge on that date from SEK 320 million to SEK 685 million – SEK 249 million attributable to

the options with a strike price of SEK 660 and SEK 115 million attributable to the options with a strike

price of SEK 700.

97. To determine if the Bank had created similar distortions in the reported Edge in prior years, I

checked the trading files of the Bank to see if there were other inactive orders at critical reporting dates

such as year-end or mid-year. However, since I only had access to sufficient trading data dating back to

January 2008, I focused my searches on mid-year 2008 and 2009 and year-end 2008.92

98. For mid-year 2009, I found four trades on 30 June 2009 that showed a similar pattern as the one

described before. As shown in Table 13 below, I found four positions in the daily volatility reviews with

a negative HQ Bank Edge which totaled SEK 358 million.

91 HQ Bank Daily Volatility Reviews, (NAV-17) 92 The data in the trading files for 2007 was limited to 38 trades. Moreover, the daily volatility reviews only dated back to

February 2009.


Date Contract Position StrikePrice of

OMXS30 Res(mkt/th) MV(theor) MV(mkt/th) MV(market)HQ Bank

EdgeTheoretical

Price

29-Dec-09 OMXS30 A660 (11,500) 660 965.95 (249,297,172) (351,784,672) (351,784,672) - - 305.9030-Dec-09 OMXS30 A660 (11,500) 660 951.86 16,237,500 (335,586,134) (86,250,000) (86,250,000) (249,336,134) 291.8104-Jan-10 OMXS30 A660 (11,500) 660 963.69 (246,712,948) (349,200,448) (349,200,448) - - 303.65


Date Contract Position StrikePrice of

OMXS30 Res(mkt/th) MV(theor) MV(mkt/th) MV(market)HQ Bank

EdgeTheoretical

Price

29-Dec-09 OMXS30 A700 (6,010) 700 965.95 (123,498,180) (159,809,680) (159,809,680) - - 265.9130-Dec-09 OMXS30 A700 (6,010) 700 951.86 251,500 (151,344,018) (36,060,000) (36,060,000) (115,284,018) 251.8204-Jan-10 OMXS30 A700 (6,010) 700 963.69 (122,146,654) (158,458,154) (158,458,154) - - 263.66

*Res(mkt/th), MV(theor), MV(mkt/th), MV(market), and Edge amounts are in SEK.

Page 42

Table 13 – Positions with Inactive Orders at 30 June 200993

99. As Table 13 also reveals, there was no negative HQ Bank Edge for these positions in the days

leading up to this “typical” financial reporting date and the negative Edge was eliminated just days after

the reporting date. Thus, it would appear that the inactive orders were similarly entered in order to reduce

the Bank’s overall reported Edge to give an impression that the portfolio was not being valued

significantly different from market values.94 Moreover, given the price of the underlying index and the

strike prices of the options, the inactive order prices shown in Table 13 are clearly not market prices.95

100. For year-end 2008, I reviewed the 22 December 2008 volatility review – the date closest to year-end

2008 – because I did not have the daily volatility reviews prior to 2009. On 22 December 2008, I found

three positions with negative Edges. As shown in Table 14 below (except as of 25 August 2008 for the

call option with a strike price of SEK 860), the portfolio reviews did not contain an Edge for these

93 HQ Bank Daily Volatility Reviews, (NAV-17); HQ Bank Trading Files, (NAV-18)

94 I noted that the prices of the inactive orders did not affect the quoted prices I obtained for the market as of the 26 June 2009 or 28 July 2009 volatility reviews. Thus, I did not have to revise the Navigant Edge for these review dates.

95 In the case of the M900 put option, it is nonsensical to enter a bid price of SEK 30 when the intrinsic value is SEK 104 since no one would ever agree to transact at that price. The intrinsic value for a put option is the strike price less the market value of the underlying stock or index. It is the value that an option holder can receive if the option is exercised without taking into account the time value of the option. The total value of an option is the combination of the intrinsic value and the time value of the option. Likewise, for the M980 put option, it is nonsensical to enter a bid price of SEK 40 when the intrinsic value is SEK 184. In the case of the L4000 call option, it is nonsensical to enter an ask price of EUR 1,500 that is nearly two times the intrinsic value of the option of EUR 807. Finally, it is also nonsensical to enter an ask price of EUR 18 for the L7000 option given that the option was deep out of the money.

(Edge amounts in SEK millions; Order and Index prices in EUR (ODAX) and SEK (OMXS30)

Expiration DateOption

HQ Bank Edge

Price of Inactive Order

Price of Underlying

IndexHQ Bank

Edge


Price of Underlying

IndexHQ Bank

Edge


Price of Underlying

IndexHQ Bank

Edge


Price of Underlying

Index SEK EUR EUR SEK EUR EUR SEK SEK SEK SEK SEK SEK

23-Jun-09 - 4,717.50 - 4,717.50 - 754.21 - 754.21 24-Jun-09 - 4,837.00 - 4,837.00 - 783.76 - 783.76 25-Jun-09 - 4,806.50 - 4,806.50 - 779.26 - 779.26 26-Jun-09 - 4,775.50 - 4,775.50 - 787.05 - 787.05 29-Jun-09 - 4,883.50 - 4,883.50 - 804.53 - 804.53 30-Jun-09 (127) 1,500.00 4,807.50 (47) 18.00 4,807.50 (54) 30.00 796.01 (130) 40.00 796.01 01-Jul-09 (107) 4,911.00 (42) 4,911.00 (39) 813.88 (107) 813.88 02-Jul-09 (39) 4,717.00 - 4,717.00 - 792.61 - 792.61 03-Jul-09 - 4,704.00 - 4,704.00 - 790.60 - 790.60 06-Jul-09 - 4,659.00 - 4,659.00 - 783.47 - 783.47 08-Jul-09 - 4,576.00 - 4,576.00 - 777.58 - 777.58 09-Jul-09 - 4,633.00 - 4,633.00 - 778.06 - 778.06 10-Jul-09 - 4,574.00 - 4,574.00 - 774.19 - 774.19 13-Jul-09 - 4,739.50 - 4,739.50 - 786.05 - 786.05

Daily Volatility Review Date

18-Dec-09Call ODAX L4000

18-Dec-09Call ODAX L7000

22-Jan-10Put OMXS30 M900

22-Jan-10Put OMXS30 M980

Page 43

positions previously or after the 22 December 2008 volatility review. However, as of 22 December 2008

the three positions had a negative Navigant Edge totaling SEK 233 million.

Table 14 – Volatility Reviews for OMXS30 Puts with Strike Prices of SEK 980 and SEK 940 and Call with Strike Price of SEK 860 with Expiration 22 January 201096

96 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); Navigant Edge Database, (NAV-23) I observed that

for the put option with an SEK 980 strike price, HQ Bank chose the SEK 200 value of the inactive order placed on 19 December 2008 rather than the SEK 150 value of the inactive order placed on 22 December 2008 as show in Table 15 below.

Volatility Review

Price of OMXS30 MV(mkt/th) MV(theor)

Navigant Edge

HQ Bank Edge

Navigant Market

Price HQ Bank

Market Price Theoretical

Price

Put Option Strike Price of SEK 98027-May-08 997.50 (6,193,539) (6,193,539) - - 30.97 23-Jun-08 922.50 (51,518,251) (51,518,251) - - 51.52 28-Jul-08 856.50 (73,349,483) (73,349,483) - - 77.21 25-Aug-08 863.50 (81,097,460) (81,097,460) - - 85.37 24-Sep-08 819.25 (106,904,788) (106,904,788) - - 112.53 27-Oct-08 575.00 (306,212,587) (306,212,587) - - 322.33 25-Nov-08 643.50 (248,635,328) (248,635,328) - - 261.72

22-Dec-08 659.00 (190,000,000) (270,041,408) (127,541,408) (80,041,408) 150.00 200.00 284.25

27-Jan-09 611.50 (294,895,595) (294,895,595) - - 310.42 23-Feb-09 632.75 (287,524,945) (287,524,945) - - 302.66 25-Mar-09 637.25 (298,391,362) (298,391,362) - - 314.1

Put Option Strike Price of SEK 94023-Apr-08 959.25 (12,565,016) (12,565,016) - - 31.41 27-May-08 997.50 (8,064,642) (8,064,642) - - 20.16 23-Jun-08 922.50 (14,154,069) (14,154,069) - - 35.39 28-Jul-08 856.50 (22,208,064) (22,208,064) - - 55.52 25-Aug-08 863.50 (25,397,745) (25,397,745) - - 63.49 24-Sep-08 819.25 (47,440,494) (47,440,494) - - 86.26 27-Oct-08 575.00 (157,935,130) (157,935,130) - - 287.15 25-Nov-08 643.50 (125,510,599) (125,510,599) - - 228.2

22-Dec-08 659.00 (135,978,670) (135,978,670) (39,728,670) - 175.00 247.23

27-Jan-09 611.50 (149,885,249) (149,885,249) - - 272.52 23-Feb-09 632.75 (145,445,953) (145,445,953) - - 264.45 25-Mar-09 637.25 (151,463,323) (151,463,323) - - 275.39

Call Option Strike Price SEK of 86028-Jul-08 856.50 250,766,306 250,766,306 - - 100.31 25-Aug-08 863.50 262,480,966 262,480,966 (5,019,034) - 107 104.99 24-Sep-08 819.25 159,930,298 159,930,298 - - 72.7 27-Oct-08 575.00 31,896,528 31,896,528 - - 17.72 25-Nov-08 643.50 24,331,626 24,331,626 - - 30.41

22-Dec-08 659.00 88,200,000 22,737,935 (65,462,065) (65,462,065) 42.00 42.00 10.83

27-Jan-09 611.50 12,890,602 12,890,602 - - 6.14 23-Feb-09 632.75 - - - - 6.42 25-Mar-09 637.25 - - - - 4.3

Page 44

101. I confirmed that these negative Edges were the product of inactive orders placed by HQ Bank on 22

December 2008 for these three positions. As Table 15 below shows, the Bank’s trading data showed an

inactive order of SEK 42 placed for the call option and inactive orders of SEK 150 and SEK 175 placed

for the put options with strike prices of SEK 980 and SEK 940, respectively.

Table 15 — HQ Bank Trade Data for OMXS30 Puts with Strike Prices of SEK 980 and SEK 940 and Call with Strike Price of SEK 860 with Expiration 22 January 201097

102. The inactive order prices of the two put options of SEK 150 and SEK 175 are nonsensical given that

the intrinsic value of these options was SEK 321 and SEK 281, respectively.98

97 HQ Bank Trading Files, (NAV-18)

Put Option Strike Price of SEK 980

Order Created

Type of Trade


Trade Price Created (t)

19-Dec-08 Inactive order B 10 200 1:05:51 PM


23-Dec-08 Inactive order B 10 210 9:35:43 AM02-Jan-09 Inactive order B 10 200 4:25:13 PM

Put Option Strike Price of SEK 940

Order Created

Type of Trade





23-Dec-08 Inactive order B 10 175 11:33:47 AM29-Dec-08 Inactive order B 10 160 1:45:28 PM

Call Option Strike Price of SEK 860

Order Created

Type of Trade



22-Dec-08 Inactive order S (10) 42 12:28:22 PM

23-Dec-08 Inactive order S (10) 51 5:15:25 PM29-Dec-08 Inactive order S (10) 40 9:30:12 AM02-Jan-09 Inactive order S (10) 60 3:32:35 PM09-Jan-09 Inactive order S (10) 45 10:42:11 AM

Page 45

103. To further confirm that the inactive prices entered by HQ Bank were not realistic market prices, I

reviewed the quoted market prices of other puts and calls on the OMXS30 index expiring 22 January

2010 held by HQ Bank as of 22 December 2008, but with different strike prices. As shown in Table 16

below, the put price increases as the strike prices increases and the call price decreases as the strike prices

increases. However, the inactive order prices for the three positions just reviewed violate this expected

pattern.

Table 16 – Quoted Market Prices on 22 Dec 2008 for OMXS30 Puts and Calls with Expiration 22 January 201099

104. Ignoring these artificial market prices from the 22 December 2008 Volatility Review increases the

Navigant Edge on that date from SEK 264 million to SEK 496 million.

105. For mid-year 2008, I did not find any trades that showed a similar pattern as the ones described

above.

106. In Figure 7 below, I have revised my own calculation of the Edge to correct for the distortions at 22

December 2008 and 30 December 2009 previously described.

98 The price of the underlying OMX index as of 22 December 2008 was SEK 659. 99 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); Navigant Edge Database, (NAV-23)

Puts Calls22-Dec-08 OMXS30 22-Jan-10 340 300.0022-Dec-08 OMXS30 22-Jan-10 600 74.7522-Dec-08 OMXS30 22-Jan-10 640 95.50 95.0022-Dec-08 OMXS30 22-Jan-10 660 85.2522-Dec-08 OMXS30 22-Jan-10 700 67.0022-Dec-08 OMXS30 22-Jan-10 780 177.25 33.5022-Dec-08 OMXS30 22-Jan-10 860 42.0022-Dec-08 OMXS30 22-Jan-10 900 272.0022-Dec-08 OMXS30 22-Jan-10 940 175.0022-Dec-08 OMXS30 22-Jan-10 980 150.00

22-Dec-08 OMXS30 22-Jan-10 1040 402.2522-Dec-08 OMXS30 22-Jan-10 1080 410.00

Strike Price

Quoted Market PricesPrice Date Index

Expiration Date

Figure 7

107. Seco

positions

100 Navigan

7 – Revised E

ond, I evaluat

and liability p

nt Edge Database

Evolution o

ted the Edge

positions over

e, (NAV-23)

f HQ Bank’

e in the prop

r time. Figur

’s Edge for

rietary tradin

re 8 below sho

Put and Ca

ng portfolio b

ows the Navig

all Options10

by breaking

gant Edge in

Pag

00

it down into

this manner.

ge 46

asset

Page 47

Figure 8 – Navigant Edge for Put and Call Options by Assets and Liabilities101

108. Figure 8 above indicates that the Bank consistently undervalued its liabilities relative to trading

prices, but more fairly valued its assets until early 2009. At that time, the Bank began significantly

undervaluing its assets. This timing coincides with the Bank’s increased trading in the DAX versus the

OMXS30. By late 2009, however, the Bank was overvaluing both its assets and undervaluing its

liabilities relative to market prices.

109. I analyzed the Bank’s liability positions in greater detail. I determined that the Edge associated with

the Bank’s liabilities increased significantly beginning on 28 July 2009. At that time, the Navigant Edge

was SEK 315 million. By 25 August 2009, the Navigant Edge increased to SEK 626 million or almost


(800)

(600)

(400)

(200)

-

200

400

600

800

1,000

1,200

Am

ount

s in

SE

K m

illi

ons

Asset Liability

Page 48

200 percent.102 The largest contribution to this increase in the Edge came from the Bank’s liability DAX

positions expiring 18 June 2010 as shown in Table 17 below.

Table 17 – Change in HQ Bank’s DAX Call and Put Positions Expiring 18 June 2010103

110. As Table 17 above indicates, the Bank sold an additional 39,500 calls option contracts between 28

July 2009 and 25 August 2009 volatility reviews, thereby increasing its liability. The DAX index,

however, increased almost 2 percent over the same time period as shown in Figure 9 below.

102 See Figure 7; Navigant Edge Database, (NAV-23) 103 Navigant Edge Database, (NAV-23)

Asset Liability Asset Liability Asset Liability Asset Liability28-Jul-09 - (12,000) - - (12,000) - 33 - - 33 25-Aug-09 - (51,500) 11,000 (16,500) (57,000) - 268 (74) 85 279 28-Sep-09 - (43,500) - (16,500) (60,000) - 333 - 73 406 21-Oct-09 29,200 (53,500) 16,500 (33,000) (40,800) (81) 368 (86) 198 399 27-Nov-09 66,200 (73,500) 31,500 (57,000) (32,800) (70) 504 (171) 361 624 29-Dec-09 114,200 (102,500) 18,000 (60,250) (30,550) 70 203 (77) 215 411 30-Dec-09 114,200 (100,000) 3,000 (60,250) (43,050) 59 197 (13) 225 467 28-Jan-10 141,650 (63,325) 36,700 (116,025) (1,000) 81 (31) (152) 541 439 23-Feb-10 165,150 (55,300) 26,700 (110,050) 26,500 142 (110) (113) 363 282 24-Mar-10 127,125 (36,875) 75,700 (112,600) 53,350 128 59 26 68 280 27-Apr-10 101,125 (20,400) 25,225 (46,850) 59,100 213 (81) (29) 50 153 25-May-10 64,875 (24,850) 44,175 (35,000) 49,200 1 27 7 30 65 31-May-10 59,875 (24,850) 44,175 (35,000) 44,200 44 (40) 4 6 14

Volatility Review

Date

Positions Navigant EdgeCalls Puts

Net

Calls Puts

Net

Figure 9

111. The

record hig

the Edge,

112. To a

The optio

strike pric

position in

104 Bloombe

9 – Movemen

movement in

gher liabilitie

thereby not r

nalyze this is

n contract wi

ce of €5,300 a

n this contrac

erg, Historical D

nt in the DA

n the DAX (a

es and losses.

recognizing an

sue further, I

ith the largest

and an expira

ct over time as

DAX Index Mark

AX from 28

all other facto

However, th

ny loss.

examined the

t Edge was a l

tion date of 1

s shown in Ta

ket Prices, (NAV

July 2009 t

ors remaining

he Bank appe

e Bank’s posi

liability posit

8 December

able 18 below

V-21)

to 25 Augus

g the same) s

ears to have

itions in indiv

tion on call op

2009. The B

w.

st 2009 in SE

should have c

captured this

vidual option

ptions on the

Bank increased

Pag

EK104

caused the Ba

s negative eff

contracts in d

DAX index w

d and decreas

ge 49

ank to

fect in

detail.

with a

sed its

Page 50

Table 18 – Transactions Involving Call Options on the DAX with Strike Price of €5,300 and Expiration Date of 18 December 2009105

113. Table 18 above reveals three aspects of the Bank’s valuation methods.

114. First, the trading data indicates that the Bank established its liability position on 16 March 2009 at a

price of €92.80 and immediately revalued it at a price of €22.70, thus creating a Day 1 profit of SEK 39

million.

115. Second, the Bank added to its liability position two days later on 18 March 2009 at a price of €90.50

and immediately revalued it at a price of €18.60. Thus, the Bank was clearly ignoring its own trades in

valuing its prior positions and was using valuation techniques that resulted in significantly artificial

prices.


AB Trading Files, (NAV-18)

(Results amounts in millions)

Transaction Price

Theoretical Price

Reported

Market Cumulative

Results

Theoretical Cumulative

Results

Cumulative Realized Results

EUR EUR SEK SEK SEK

16-Mar-2009 S (10,000) (10,000) 92.80 22.70 2 39 18-Mar-2009 S (5,000) (15,000) 90.50 18.60 1 61 20-Mar-2009 S (1,000) (16,000) 94.60 21.70 2 57 20-Mar-2009 S (4,000) (20,000) 97.00 21.70 2 57 24-Mar-2009 S (10,000) (30,000) 124.20 35.60 (25) 121 24-Mar-2009 S (2,000) (32,000) 119.50 35.60 (25) 121 25-Mar-2009 30.00 (9) 131 01-Apr-2009 S (24,000) (56,000) 85.00 28.60 40 206 27-Apr-2009 93.00 (366) 11 27-May-2009 183.00 (578) (260) 22-Jun-2009 B 31,000 (25,000) 161.10 79.10 (215) (88) (112) 26-Jun-2009 B 16,000 (9,000) 159.20 102.00 (206) (118) (110) 30-Jun-2009 S (11,000) (20,000) 177.40 98.70 (202) (118) (130) 02-Jul-2009 S (7,000) (27,000) 156.40 75.40 (145) (62) (119) 06-Jul-2009 B 14,000 (13,000) 106.30 62.10 (111) (101) (112) 06-Jul-2009 B 9,000 (4,000) 110.90 62.10 (111) (101) (112) 07-Jul-2009 B 5,000 1,000 93.50 62.10 (101) (101) (112) 07-Jul-2009 B 6,000 7,000 119.70 62.10 (101) (101) (112) 13-Jul-2009 S (5,000) 2,000 107.00 74.70 (111) (116) (109) 15-Jul-2009 S (2,000) - 150.20

Date

No Transactions

No TransactionsNo Transactions

Cumulative Position

Transaction Volume

Bought or Sold

116. Third

theoretica

position t

purposes)

Figure 1Options

117. As F

position o

from the p

one posit

respective

106 HQ Bank

Trading F107 See HQ

(NAV-17)

d, the Bank w

al prices when

the Bank esta

and the cumu

0 – Aggregawith a Strik

Figure 10 abo

on its financia

position. Ind

ion alone wo

ely.107 Ultim

k Volatility RevFiles, (NAV-17)

Bank Edge in th)

was eventuall

n it exited the

ablished in th

ulative marke

ate Theoretke Price of €

ove reveals, th

al statements v

deed, the Ban

ould have be

ately, once th

views, May 2007

he HQ Bank Dai

y forced to re

e position. In

his contract o

et position (i.e

tical and Ma€5,300 and E

he Bank used

vis-à-vis mark

nk’s reported

en higher by

he Bank bega

7 through May 20

ly Volatility Rev

econcile these

n Figure 10 b

over time (i.

e. the profit o

arket ResultExpiration

d theoretical p

ket prices, the

profits in the

y approximate

an to unwind

010, (NAV-16);

views at the end

e substantial

below, I com

e. the profit

or loss using m

ts for HQ Bof 18 Decem

prices to sign

ereby increas

e first and sec

ely SEK 130

d its position

HQ Bank Daily

of the first quar

deviations in

mpare the theo

or loss for f

market prices)

Bank’s Liabmber 200910

ificantly unde

ing the profit

cond quarters

0 million and

at market pri

y Volatility Revi

rter 2009 and sec

Pag

n market price

oretical cumu

financial repo

).

ility DAX C06

ervalue its lia

ts it was gene

s of 2009 from

d SEK 83 m

ices, the diffe

iews; HQ Bank

cond quarter 200

ge 51

es and

ulative

orting

Call

ability

rating

m this

illion,

erence

09,

Page 52

between the theoretical value (the carrying value in the financial statements) and the market value

converged.

118. Given the significant difference between the Bank’s theoretical valuation of its option positions and

the valuation of those positions using trading prices, I analyzed additional positions to determine whether

the same valuation distortions occurred across the end of each calendar year when the financial statements

of the Bank would have been audited. I found these distortions at the end of every calendar year from

2007 to 2009. I discuss some examples of these in the following subsections.

ii. Edges that Straddle Year-End Financial Reporting Dates

119. With respect to year-end 2009, the Bank took an asset position in call options on the DAX index

with a strike price of €6,200 and expiration date of 19 March 2010. As Figure 11 below shows, the Bank

consistently valued its position significantly above market prices until the Bank exited the position

between 21 and 26 January 2010 and was forced to recognize significant losses. While the large loss

ultimately recognized appears to have been the result of a sharp decline in the DAX index in January

2010, the valuation pattern of this position is consistent with the prior position I analyzed: the Bank

recorded a theoretical value that overstated the Bank’s position vis-à-vis a market value and only

reconciled this difference when it exited the position.

Figure 1with a St

120. Inter

trade to m

million.109

same. Su

On 11 No

to its posi

use this pu

contract a

108 HQ Ban

AB Tradin109 HQ Bank110 HQ Bank

1 – Aggregatrike Price o

restingly, with

market (i.e. us9 This is sho

ubsequently, h

ovember 2009

ition by purch

urchase price

as shown in F

nk Volatility Revng Files, (NAV-k Volatility Rev

k Volatility Rev

ate Theoretof €6,200 an

h respect to th

sed a Level 1

own in Figur

however, the

9, about 19 da

hasing 13,000

e to value its t

Figure 12 bel

views, May 2007-18) views, May 2007

views, May 2007

tical and Mand Expiratio

he position re

valuation me

re 11 above w

Bank began

ays after estab

0 additional c

total position

low.110 Thus

7 through May 2

7 through May 20

7 through May 20

arket Resulton of 19 Ma

eflected in Fi

ethod) on 23

where the the

valuing the

blishing its ini

contracts at a

of 20,000 con

, the Bank re

010, (NAV-16);

010, (NAV-16);

010, (NAV-16);

ts for HQ Barch 2010108

igure 11 abov

October 200

eoretical and

position usin

itial position

a price of €11

ntracts, the B

ecorded a Day

; HQ Bank Daily

HQ Bank Daily

HQ Bank Daily

Bank’s DAX8

ve, the Bank i

09 resulting in

market valu

ng its own su

in this contra

14.50 per con

Bank used a pr

y 1 profit on

y Volatility Revi

y Volatility Revi

y Volatility Revi

Pag

X Call Optio

initially mark

n a loss of SE

ues are initial

ubjective valu

act, the Bank a

ntract. Rather

rice of €174.9

n the new con

iews, (NAV-17)

iews, (NAV-17)

iews, (NAV-17)

ge 53

ons

ked its

EK 18

ly the

uation.

added

r than

90 per

ntracts

); HQ

acquired a

most rece

Figure 1Call Opt

121. Figu

trading pr

122. With

price of €

2009. Th

price of €

the tradin

111 HQ Ban

AB Tradin

and a profit o

nt purchase p

2 – Transactions with a

ure 12 above

rices at which

h respect to ye

€5,000 beginn

he initial posi

€609.60 per co

ng day. How

nk Volatility Revng Files, (NAV-

on the previou

price.

ction Price a Strike Pric

shows that t

h the Bank reg

ear-end 2008

ning on 19 D

tion taken by

ontract. I am

wever, on 22

views, May 2007-18)

usly owned co

and Reportce of €6,200

the Bank mai

gularly purcha

, I analyzed a

December 200

y the Bank w

m not certain w

2 December 2

7 through May 2

ontracts using

ed Theoretiand Expira

intained a va

ased and sold

a liability pos

08 and lastin

as a liability

what price the

2008 (the fo

010, (NAV-16);

g a price more

ical Fair Vaation of 19 M

alue for this p

d this contract

ition the Ban

ng until the e

position in 1

e Bank assign

ollowing tradi

; HQ Bank Daily

e than 50 perc

alue for HQMarch 2010

position cons

t.

nk held in the

xpiration dat

0,000 call op

ned to this po

ing day), the

y Volatility Revi

Pag

cent higher th

Q Bank’s DA0111

sistently abov

DAX with a

te of 18 Dece

ption contract

sition at the e

e Bank assig

iews, (NAV-17)

ge 54

han its

AX

ve the

strike

ember

ts at a

end of

ned a

); HQ

Page 55

theoretical price to this contract of €344, a price approximately 44 percent lower than the purchase

price.112

123. As Figure 13 below shows, the Bank’s reported theoretical results at 31 December 2008 did not

accurately reflect market results. As such, the reported values on the Bank’s income statement were

artificially distorted. The Navigant Edge reported for this position was SEK 103 million as of 22

December 2008.113 I did not have sufficient Daily Reviews to identify the reported Edge exactly at year-

end 2008, but note that the reported Navigant Edge on 27 January 2009 had increased to SEK 136

million.114

112 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); HQ Bank Daily Volatility Reviews, (NAV-17)



Page 56

Figure 13 – Aggregate Theoretical and Market Results for HQ Bank’s Liability DAX Call Options with a Strike Price of €5,000 and Expiration of 18 December 2009115

124. I found that the Bank’s liability position in these call options is interesting for two additional

reasons.

125. First, the initial liability position established by the Bank was a successful position. At the end of

2008 and beginning of 2009, equity markets around the world (including the DAX) dropped significantly.

According to the Volatility Reviews, the Bank exited its liability position with a realized profit exceeding

SEK 500 million.116 Even though the trade was performing extremely well, the Bank maintained an Edge

which increased the Bank’s reported profits by approximately one third (sometimes less, sometimes

more). This extra profit was eliminated when the Bank exited the position.


AB Trading Files, (NAV-18) 116 See 25 March 2009 data in the HQ Bank Daily Volatility Reviews, (NAV-17)

Page 57

126. Second, the Bank took a second liability position in this same contract beginning in May of 2009.

The Bank built up a liability position in 32,700 contracts by 30 June 2009 and an Edge of SEK 187

million.117 A summer rally in the DAX, however, made the trade unprofitable. By 6 August 2009, the

Bank had purchased 29,500 contracts to reduce its liability position at a significant loss.118 The remaining

liability position of 3,500 contracts was offset at expiration. This second liability position essentially

wiped out the realized gain of SEK 500 million generated from the first liability position, thus

demonstrating the size of the gambles being taken by the Bank during 2009.

127. With respect to year-end 2007, I analyzed the Bank’s OMXS30 derivative positions to find an

example that spans year-end 2007. I did not have trade data available for 2007. Moreover, the Bank did

not report realized results in 2007. As such, my analysis of the OMXS30 positions is only based on the

reported theoretical values and market values available in the 2007 and 2008 Volatility Reviews.

128. I identified a liability position the Bank established in call options on the OMXS30 with a strike

price of SEK 1,300 and an expiration of 23 January 2009 prior to 22 August 2007. As shown in Figure

14 below, the Bank initially recorded these options at a theoretical price of SEK 33.98 (purple line), much

lower than the market price of SEK 92.5 (green line) at the August Volatility Review, thus generating a

Navigant Edge of SEK 25 million. At 18 December 2007, the last volatility review prior to the calendar

year-end, the reported theoretical price (SEK 8.77) and market price (SEK 35) continued to differ

significantly, thus generating a Navigant Edge of SEK 41 million. However, after the year-end, the

reported theoretical price is adjusted to the market price of SEK 1.54 on 25 January 2008. There is,

therefore, no Edge in 2008.

117 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); HQ Bank Daily Volatility Reviews, (NAV-17) 118 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); HQ Bank Daily Volatility Reviews, (NAV-17)

Page 58

Figure 14 – Aggregate Theoretical and Market Results for HQ Bank’s Liability OMXS30 Call Options with a Strike Price of SEK 1,300 and Expiration of 23 January 2009119

129. The position reflected in Figure 14 above appears to be an example where the Bank valued the

contract at a price at which it hoped to exit the position rather than current price. As it turns out in this

case, the contract price did decrease as the Bank hoped it would and the trade was successful. However,

the theoretical prices used by the Bank materially increased the Bank’s profits before the Bank had any

evidence that it could exit the position and secure those profits.

iii. The Volatility Factor in the Bank’s Theoretical Market Valuation

130. As I have previously explained, the data made available to me did not allow me to replicate the

theoretical values the Bank established for the positions that created the Edge. However, the data did

contain some elements that would be utilized in the valuation of call and put options – namely, the

volatility parameter (e.g., theoretical volatility). I analyzed the theoretical volatility utilized by the Bank


Page 59

to value various positions over time. From my analysis, I was not able to find any systematic

determination of the theoretical volatility for a position. For example, I could not identify if the Bank was

using the historical volatility of the instrument as it indicated in its annual reports. I also could not

identify if the Bank was using the implied volatility for at the money (“ATM”) options as I understand

KPMG and Dyrefors have indicated HQ AB was doing.120 I calculated the historical volatility for various

periods of time. However, none of my calculations appeared to explain the theoretical volatility

ultimately utilized by the Bank in the valuation of the instrument.

131. In Table 19 below, I provide an example of the various volatility parameter calculations I made for

all positions in the DAX expiring on 18 December 2009. First, I have performed my volatility parameter

calculations for all positions regardless of their strike price because that is how the Bank determined their

volatility parameters. I previously explained in Section II that using the same volatility parameter

regardless of strike price can lead to distorted valuations since the implied volatility for the option

decreases with an increasing strike price. Second, I have reviewed the at-the-market implied volatility for

these DAX options.

120 At the money options are options with a strike price that is equal to the price of the underlying stock or index.

Page 60

Table 19 – Historical Volatility and ATM Implied Volatility for DAX Options Expiring 18 December 2009121

132. Table 19 above confirms that the Bank was using just one volatility parameter, regardless of the

strike price, for all positions in DAX options expiring 18 December 2009. Table 19 also shows that the

choice of the volatility parameter does not follow any historical average or the implied volatilities of the

ATM options.

133. Similarly, in Table 20 below I provide an example of the various volatility parameter calculations I

made for all positions in the OMX expiring on 25 January 2008. Again, I performed my volatility

parameter calculations for all positions regardless of strike price because that is how the Bank determined

their volatility parameters.

121 Bloomberg, Historical and ATM Implied Volatilities for Options on the DAX Index, (NAV-24); HQ Bank Volatility

Reviews, May 2007 through May 2010, (NAV-16); See also Appendix 4. The ATM volatility represents the weighted average of the implied volatilities of the two options with the closest strikes to price of the DAX. The ATM implied volatilities in Table 19 above are based on the time to expiration. Historical ATM implied volatilities were available for the following periods: one month, two months, three months, six months, and one year. Where the time to expiration in days exceeded a specific period (or was not within a few days of the period), the next period ATM implied volatility was used. For example, at 298 days to expiration (in the case of the 23 February 2009 volatility review), the one year ATM implied volatility was used.

10 Days 30 Days 90 Days 1 year

22-Dec-08 25.00 19.53 52.45 55.67 33.32 361 36.7427-Jan-09 23.00 27.03 28.42 56.53 33.83 325 37.2723-Feb-09 20.00 30.54 37.28 50.17 34.73 298 39.5825-Mar-09 20.00 19.63 39.60 42.32 36.01 268 34.6927-Apr-09 20.00 33.66 34.29 36.35 37.10 235 33.0127-May-09 20.00 25.25 28.88 35.81 37.45 205 28.2026-Jun-09 20.00 26.17 26.87 34.04 36.77 175 28.8128-Jul-09 25.00 17.27 27.48 29.98 36.96 143 25.7525-Aug-09 24.00 24.95 21.47 26.36 36.72 115 25.5128-Sep-09 25.00 20.73 19.32 24.16 36.75 81 25.4021-Oct-09 26.00 22.07 20.67 23.39 36.94 58 23.5927-Nov-09 30.00 26.41 24.01 22.39 37.25 21 24.47

Historical Period Evaluated:Volatility Review

DateBank

Volatility

Hitorical Volatility ATM Implied

Volatility

Time to Expiry (Days)

Page 61

Table 20 – Historical Volatility and ATM Implied Volatility for OMX Options Expiring 25 January 2008122

134. Table 20 above confirms that the Bank was using just one volatility parameter regardless of the

strike price for all positions in OMX options expiring on 25 December 2008 during 2007, even though

HQ AB did not indicate it was doing so until the 2008 financial statements were published. Table 20 also

shows that the choice of the volatility parameter does not follow any historical average or the implied

volatilities of the ATM options.

iv. Rolling Edge

135. The fact that the Bank had a continuous and growing Edge also indicated to me that the Bank was

likely rolling over the Edge from one position and establishing it immediately into another. I, therefore,

summarized the Edge for all instruments with the same expiration date to see if there was a pattern of

122 Bloomberg, Historical and ATM Implied Volatilities for Options on the Nasdaq OMX Index, (NAV-25); HQ Bank Volatility

Reviews, May 2007 through May 2010, (NAV-16); See also Appendix 4. The ATM volatility represents the weighted average of the implied volatilities of the two options with the closest strikes to the price of the OMX 30. The ATM implied volatilities in Table 20 above are based on the time to expiration. Historical ATM implied volatilities were available for the following periods: one month, two months, three months, six months, and one year. Where the time to expiration in days exceeded a specific period (or was not within a few days of the period), the next period ATM implied volatility was used. For example, at 228 days to expiration (in the case of the 11 June 2007 volatility review), the one year ATM implied volatility was used. A historical ATM volatility was unavailable for 24 May 2007. As such, the ATM volatility reflected in Table 20 above is the volatility from the next closest day prior to 24 May 2007 of 18 May 2007.

10 Days 30 Days 90 Days 1 year

24-May-07 13.00 14.82 15.70 17.46 18.82 246 19.4928-May-07 13.50 12.88 15.60 17.46 18.83 242 20.6611-Jun-07 14.00 25.03 19.31 18.89 19.17 228 20.9725-Jun-07 13.00 18.93 19.16 19.41 19.29 214 21.6025-Jul-07 13.00 15.70 16.42 17.10 19.39 184 22.0422-Aug-07 13.00 35.81 27.72 21.20 20.57 156 25.1624-Sep-07 13.00 28.08 26.42 23.51 21.34 123 24.5125-Oct-07 15.00 30.09 24.19 23.95 20.41 92 26.8726-Nov-07 18.00 20.49 20.39 24.62 19.25 60 30.6418-Dec-07 25.00 22.46 23.34 23.25 19.19 38 25.4925-Jan-08 40.00 49.73 32.95 26.38 20.80 0 38.16

Hitorical VolatilityVolatility Review

DateBank

VolatilityHistorical Period Evaluated:

ATM Implied

Volatility

Time to Expiry (Days)

Page 62

transferring the Edge from one position into a new position. Figure 15 below summarizes the Edge for all

instruments with the same expiration date that make up the majority of the Edge.

Figure 15 – Navigant Edge for HQ Bank’s Options on the OMXS30 and DAX Indices at Various Expiration Dates123

136. Figure 15 above shows the contracts by expiration date constituting the majority of the Edge. Figure

15 reveals that the Edge was originally concentrated in a liability position in call and put options expiring

on 25 January 2008 (blue bars). A second material source for the Edge appeared in June 2007 in a

liability position in call and put options expiring on 23 January 2009 (tan bars). As the liability position

in the calls expiring on 25 January 2008 approached expiration (blue bars), a new Edge was established in

a liability position in call and put options expiring 18 July 2008 (dark green bars). Then, as the expiration

123 Navigant Edge Database, (NAV-23); The Edge values as of 22 December 2008 and 30 December 2009 have been updated

similarly to Figures 7 and 8 described above.

Page 63

date approached for the liability position in calls expiring on 23 January 2009 (tan bars), a new Edge was

established in a liability position in call and put options expiring on 18 December 2009 (dark purple bars).

In mid-2009, the Bank established a new liability position in call and put options expiring on 18 June

2010 with a significant Edge (light pink bars). In late 2009, the Bank established an Edge in a liability

position in call and put options expiring on 19 March 2010 (yellow bars) which replaced the Edge in call

and put options expiring on 18 December 2009 (dark purple bars). In March 2010, the Edge in call and

put options expiring on 19 March 2010 (yellow bars) is replaced with an Edge in call and put options

expiring on 17 December 2010 (light purple bars). Finally, in April 2010 an Edge in call and put options

expiring on 17 September 2010 (light green bars) is established and grown to replace the Edge in call and

put options expiring on 18 June 2010 (light pink bars). Thus, Figure 15 above indicates that the Edge has

been transferred from one position to the next over time since 2007.

v. Analysis of Positions at Year-End 2007, 2008, and 2009

137. I have analyzed the specific positions that contributed to the Edge at the end of 2007, 2008, and

2009. I discuss each year-end in turn in the following paragraphs.

(a) Year-End 2007

138. As of the 18 December 2007 volatility review date and as shown in Table 21 below, 15 positions

account for 93 percent of the total Navigant Edge. None of these positions traded on 18 December 2007,

and for a number of positions the last trade occurred more than 5 trading days prior to the December 2007

volatility review. For all positions, however, the ask/settlement prices at 18 December 2007 appear to be

reasonable estimates of market prices considering the movements in the price of the underlying index

between the last trade and 18 December 2007. Therefore, I conclude that the ask/settlement prices at 18

December 2007 reflect market prices.

Page 64

Table 21 – Top Positions by Navigant Edge as of 18 December 2007124

139. For example, for each of the seven OMXS30 put liability positions, the ask/settlement prices for

those positions increased as the price of the underlying index or stock decreased between the last trade

date and 18 December 2007 (consistent with typical movements in price for put option). On the other

hand, the theoretical price assigned by the Bank decreased as the underlying index for these positions

decreased (just the opposite of the typical movement in price for put options).

140. Similarly, for the four OMXS30 and two NOA3 liability call positions, the price of the underlying

index also decreased between the last trade date and 18 December 2007. As I would expect, the price for

the call options on the OMXS30 also decreased. While the theoretical prices assigned by the Bank to

these options also decrease they are too low given the movement in the underlying OMXS30 index.

141. For the OMXS30 call option expiring 23 January 2009 with a strike price of SEK 980, there is no

trade available in 2007 prior to the 18 December 2007 volatility review date. However, the option traded

124 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); Navigant Edge Database, (NAV-23); Bloomberg,

Historical Prices for OMXS30, NOA3, and NDA Options for Largest Positions by Edge at Year-End 2007, (NAV-26); For the OMXS30 call option expiring 23 January 2009 with a strike price of SEK 980, there is no trade available in 2007 prior to the 18 December 2007 Volatility Review date. The price of underlying reflects the OMX at 17 December 2007.

OMXS30 1,300 Call 23-Jan-09 41,318,003 12% 8.77 35.00 Ask 1,065 14-Dec-07 2 43.25 1,098

OMXS30 1,080 Put 22-Feb-08 36,239,088 11% 27.91 54.75 Ask 1,065 05-Dec-07 9 38.25 1,102

OMXS30 1,120 Put 22-Feb-08 35,227,986 11% 51.55 76.75 Ask 1,065 30-Nov-07 12 55.50 1,107

OMXS30 1,100 Put 23-Jan-09 28,830,955 9% 65.09 122.75 Ask 1,065 03-Dec-07 11 109.50 1,102


OMXS30 920 Put 18-Jul-08 24,238,357 7% 4.37 39.00 Ask 1,065 14-Dec-07 2 29.00 1,098

OMXS30 900 Put 18-Jul-08 21,342,512 6% 2.76 33.25 Ask 1,065 05-Dec-07 9 26.25 1,102

OMXS30 900 Put 23-Jan-09 13,757,305 4% 5.83 49.50 Ask 1,065 17-Dec-08 1 45.00 1,068

NOA3 18 Call 18-Dec-09 12,635,778 4% 8.24 9.17 Settlement 25 10-Dec-07 6 11.08 27.14

OMXS30 980 Call 23-Jan-09 12,502,197 4% 124.33 166.00 Ask 1,065 17-Dec-08 1,068

NDA 120 Call 16-Jan-09 12,065,424 4% 2.54 7.00 Ask 106 26-Nov-07 16 5.95 82

OMXS30 1,280 Call 18-Jul-08 11,601,836 3% 2.45 13.50 Ask 1,065 10-Dec-07 6 20.75 1,131


OMXS30 980 Put 23-Jan-09 10,842,071 3% 19.04 73.25 Ask 1,065 06-Dec-07 8 60.00 1,105

NOA3 28 Call 18-Dec-09 10,161,714 3% 3.02 4.09 Settlement 25 03-Dec-07 11 5.91 27.46

Total Navigant Edge for Missvalued Contracts 310,129,906 93%

Total Navigant Edge for Remaining Contracts 22,160,206 7%

Total Navigant Edge at 18 December 2007 332,290,112 100%

Trading Days from

Vol. Review

Price of Underlying

Trade DateLast Price

Closest Trade before Volatility Review Date

Underlying Strike

ContractMarket Price Used

Price of UnderlyingCall /

PutExpiration Date Navigant Edge

Navigant Market Price

% of Total

Navigant Edge

HQ Bank Theor. Price

Page 65

the next day (19 December 2007) at SEK 162.125 The lower price of SEK 162 on 19 December 2007 (as

compared to SEK 166 pursuant to the ask price on 18 December 2007) makes sense given the decrease in

the OMXS30 from SEK 1,065 on 18 December 2007 to 1,064 on 19 December 2007.

(b) Year-End 2008

142. As of the 22 December 2008 volatility review shown in Table 22 below, 27 positions account for

nearly the entire Navigant Edge of SEK 496 million. Approximately half of these positions traded on 22

December 2008. For those positions that did not trade on 22 December 2008, the majority did trade

within five trading days of 22 December 2008. Similar to 2007, the bid/ask/settlement prices at 22

December 2008 are reasonable estimates of market prices given the movements in the underlying indices

between the last trade date for each position and 22 December 2008.126

125 Bloomberg, Historical Prices for OMXS30, NOA3, and NDA Securities, (NAV-26)

126 There are two instances where the movement in the underlying security does not support the movement in the option price. However, our review of these price movements indicates that the movements can be explained by bid/ask prices that did not result in a trade (versus a settlement price) and other factors affecting the value of the option such as underlying volatility.

Page 66


143. I noted that the Bank entered 10 of the 27 top positions in Table 22 above after the 25 November

2008 volatility review.128 These positions, highlighted in grey in Table 22 above, increased the Navigant

Edge by SEK 236 million from the previously reported Navigant Edge of SEK 184 million in the 25

November 2008 volatility review. As previously mentioned in paragraphs 122-126, the most significant

contributor to the increase in the Edge was the liability position of 10,000 DAX call option contracts with

a strike price of €5,000 that the Bank entered into on 19 December 2008 at a price of €609.60. On the

following trading day, 22 December 2008, the Bank assigned a theoretical price to this contract of €344,

127 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); Navigant Edge Database, (NAV-23); Bloomberg,

Historical Prices for OMXS30, DAX, ERICB, and NOA3 Options for Largest Positions by Edge at Year-End 2008, (NAV-27) For the OMXS30 put option expiring 22 January 2010 with a strike price of SEK 640, there is no trade available in 2008 prior to the 22 December 2008 Volatility Review date. However, the ask price of the option is in line with the market prices of other OMX options with the same expiration date but different strike price. I was unable to determine the underlying price as of the closest trade prior to the 22 December 2008 Volatility Review for the HMB put options expiring 15 January 2010.

128 HQ Bank Volatility Reviews, May 2007 through May 2010, (NAV-16); Navigant Edge Database, (NAV-23)

ODAX 5,000 (10,000) Call 18-Dec-09 102,788,208 21% 344.00 529.60 Bid 4,698 22-Dec-08 - 529.60 4,698 OMXS30 900 (6,980) Put 22-Jan-10 42,516,776 9% 211.09 272.00 Settlement 656 22-Dec-08 - 272.00 656 OMXS30 780 (5,000) Put 22-Jan-10 32,500,966 7% 112.25 177.25 Ask 656 16-Dec-08 4 176.00 667 OMXS30 720 (13,000) Call 17-Jul-09 31,187,743 6% 10.76 34.75 Ask 656 2-Dec-08 14 35.00 637 OMXS30 720 (8,500) Put 17-Apr-09 29,642,744 6% 64.13 99.00 Ask 656 14-Nov-08 26 113.00 636

OMXS30 720 29,000 Call 23-Jan-09 22,433,515 5% 13.74 6.00 Bid 656 22-Dec-08 - 6.00 656 ODAX 5,000 (5,000) Call 19-Jun-09 21,992,119 4% 265.40 343.90 Settlement 4,698 22-Dec-08 - 343.90 4,698 OMXS30 640 (3,000) Put 22-Jan-10 19,013,633 4% 32.12 95.50 Ask 656 22-Dec-08

OMXS30 660 (5,500) Put 17-Jul-09 19,004,947 4% 51.20 85.75 Ask 656 8-Dec-08 10 101.50 667 ODAX 5,000 10,000 Call 20-Mar-09 17,722,124 4% 233.90 199.50 Settlement 4,698 22-Dec-08 - 199.50 4,698 ERICB 60 200,000 Put 15-Jan-10 14,993,120 3% 16.75 13.00 Settlement 60 22-Dec-08 - 13.00 60 OMXS30 600 (5,000) Put 17-Apr-09 14,894,117 3% 9.21 39.00 Settlement 656 22-Dec-08 - 39.00 656 OMXS30 1,040 (2,000) Put 22-Jan-10 12,284,106 2% 340.83 402.25 Settlement 656 22-Dec-08 - 402.25 656

ERICB 70 100,000 Put 15-Jan-10 11,571,823 2% 23.54 17.75 Bid 60 4-Dec-08 12 19.00 59 OMXS30 660 (6,500) Call 22-Jan-10 10,924,980 2% 68.44 85.25 Ask 656 16-Dec-08 4 94.50 667 OMXS30 640 (7,000) Call 22-Jan-10 10,844,635 2% 79.51 95.00 Ask 656 19-Dec-08 1 101.75 664 OMXS30 500 (4,000) Put 17-Jul-09 9,277,323 2% 1.81 25.00 Bid 656 17-Dec-08 3 32.00 664 NOA3 14 (8,521) Call 18-Dec-09 9,123,320 2% 0.26 1.24 Settlement 11 22-Dec-08 - 1.24 11 ODAX 3,500 (3,000) Put 20-Mar-09 9,090,263 2% 20.10 75.50 Settlement 4,698 22-Dec-08 - 75.50 4,698 NOA3 13 (6,400) Put 18-Dec-09 8,208,972 2% 2.46 3.62 Settlement 11 18-Dec-08 2 3.69 11 OMXS30 640 (2,000) Put 17-Apr-09 7,548,611 2% 20.76 58.50 Ask 656 19-Dec-08 1 55.00 664

OMXS30 670 9,000 Call 23-Jan-09 7,282,298 1% 29.84 21.75 Bid 656 19-Dec-08 1 29.50 664 ODAX 6,200 5,000 Call 20-Mar-09 6,976,986 1% 32.70 6.90 Settlement 4,698 22-Dec-08 - 6.90 4,698 OMXS30 640 10,000 Call 23-Jan-09 6,580,510 1% 44.58 38.00 Bid 656 19-Dec-08 1 50.00 664

NOA3 13 (5,000) Call 18-Dec-09 6,189,106 1% 0.43 1.56 Settlement 11 18-Dec-08 2 1.84 11 HMB 270 (3,990) Put 15-Jan-10 5,259,246 1% 25.82 39.00 Ask 308 9-Dec-08 8 35.50 OMXS30 710 6,500 Call 23-Jan-09 5,174,284 1% 16.21 8.25 Settlement 656 19-Dec-08 - 8.25 656

Total Navigant Edge for Missvalued Positions 495,026,474 100%

Total Navigant Edge for Remaining Contracts 1,402,251 0%

Total Navigant Edge at 22 December 2008 496,428,725 100%

Trade Date

Price of Underlying

Trading Days from

Vol. Review

Last Price


Contract HQ Bank Theor. Price


Market Price Used

Underlying PositionCall / Put

Expiration Date

Strike Navigant Edge

Price of Underlying

% of Total Navigant

Edge

Page 67

i.e. a price 43 percent lower than the purchase price.129 The Bank’s theoretical valuation for this position

(the first one listed in Table 22 above) resulted in an increase of the Navigant Edge of SEK 103 million.

144. I noted in Figures 7 and 15 above (the “rolling edge”) that the Navigant Edge drops sharply from

SEK 497 million on 22 December 2008 to less than SEK 200 million on 27 January 2009. I have

examined this decrease and have found three factors that caused the Navigant Edge to decrease.130

145. First, I noted that 4 of the 27 positions (highlighted in blue in Table 22 above) with a Navigant Edge

of SEK 41 million expired before 27 January 2009. Since these positions expired, the positions are no

longer in the portfolio and there can be no Edge associated with them.

146. Second, I noted that 6 of the 27 positions (highlighted in red in Table 22 above) with a Navigant

Edge of SEK 167 million as of 22 December 2008 had no Navigant Edge as of 27 January 2009 because a

quoted market price was not available from the OMX on that date. Since my approach in analyzing the

Edge is to use the Bank’s theoretical price when no quoted market price exists, an Edge is not established

for the remaining 3 positions.131

147. Third, the remaining decrease can be explained by a new asset position for a DAX call with a strike

price of €4,000 expiring on 18 December 2009 that the Bank entered in January which had a negative

Navigant Edge of SEK 78 million on 23 January 2009.132

(c) Year-End 2009

148. As of the 30 December 2009 volatility review shown in Table 23 below, 18 positions account for the

Navigant Edge of SEK 773 million. Eleven of these 18 positions were traded on 30 December 2009.

129 See paras. 122-126 130 I generally observed that the volatility in the Edge can be explained by three factors: 1) sometimes the market turned in favor

or against the largest positions held by the Bank causing a decrease or increase in the Edge, 2) sometimes positions expired without the Bank rolling over the Edge into new positions by the time the next volatility review was prepared, and 3) for some of the volatility review dates, there were positions that did not have an Edge because there was no market price available but previously had an edge because a market price was available (or similarly, subsequently had an Edge because a market price became available). Specifically, Figure 7 shows a significant decrease in the Navigant Edge from SEK 224 million in May 2008 to SEK 95 million in June 2008. This decrease in the Edge resulted from the Bank not rolling over the Edge from exited positions into new positions. The Bank exited several ERICB positions (with an Edge of SEK 93 million) prior to the 23 June 2008 Volatility Review. In addition, the Edge related to certain OMXS30 positions decreased by SEK 38 million as they approached their expiration of 18 July 2008. The Bank did not replace those decreases in the Edge with new positions as of 23 June 2008. The Bank, however, did enter new OMXS30 positions by the 28 July 2008 Volatility Review increasing the edge by SEK 100 million.



Page 68

Another 5 positions were traded within 5 days of the 30 December 2009 volatility review while the

remaining two positions were traded on 11 December and 18 December 2009, respectively. For those

positions that did not trade on 30 December 2009, the settlement prices at 30 December 2009 are

reasonable given the movements in the underlying DAX and OMX indices between the last trade date for

each position and the 30 December 2009 volatility review date.133


149. I also analyzed these 18 top positions using the monthly and daily volatility reviews.135 My analysis

shows a typical pattern that was occurring at the Bank in 2007, 2008, and 2009 in the valuation of its

trading portfolio. I have summarized this analysis in Table 24 below.

133 There is one instance where the movement in the underlying security does not support the movement in the option price.

However, our review of these price movements indicates that the movements can be explained by bid/ask prices that did not result in a trade (versus a settlement price) and other factors affecting the value of the option such as underlying volatility.

134 Navigant Edge Database, (NAV-23); HQ Bank Daily Volatility Reviews, (NAV-17); Bloomberg, Historical Prices for DAX Options for Largest Positions by Edge at Year-End 2009, (NAV-31)

135 The information required for this further analysis was only available regarding 2009, since I did not have Daily Reviews before February 2009.

ODAX 4,800 (30,000) Put 18-Jun-10 108,818,304 16% 17.20 87.10 Settlement 5,971 30-Dec-09 - 87.10 5,971 ODAX 6,200 (60,000) Call 18-Jun-10 93,880,801 14% 229.10 257.50 Settlement 5,971 30-Dec-09 - 257.50 5,971 ODAX 5,600 (21,750) Call 18-Jun-10 90,364,812 13% 532.80 608.90 Settlement 5,971 28-Dec-09 2 650.50 6,015 ODAX 4,850 (24,000) Put 18-Jun-10 90,185,769 13% 20.60 93.00 Settlement 5,971 11-Dec-09 12 153.80 5,766 ODAX 6,200 31,000 Call 19-Mar-10 80,956,712 12% 181.00 129.10 Settlement 5,971 30-Dec-09 - 129.10 5,971 ODAX 7,000 114,200 Call 18-Jun-10 58,568,527 9% 53.40 43.10 Settlement 5,971 29-Dec-09 - 50.40 5,971 ODAX 6,000 (8,000) Call 17-Dec-10 41,950,985 6% 464.60 562.30 Settlement 5,971 30-Dec-09 - 562.30 5,971 ODAX 5,800 27,500 Call 19-Mar-10 31,303,066 5% 365.10 340.30 Settlement 5,971 30-Dec-09 - 340.30 5,971 ODAX 4,700 (32,000) Put 19-Mar-10 30,784,302 4% 4.30 22.90 Settlement 5,971 29-Dec-09 1 20.20 6,022 OMXS30 900 (7,000) Put 21-Jan-11 22,985,920 3% 44.66 77.50 Settlement 952 30-Dec-09 - 77.50 952 ODAX 8,200 36,000 Call 17-Dec-10 22,147,694 3% 32.90 20.80 Settlement 5,971 18-Dec-09 8 23.20 5,828 OMXS30 1,000 (6,000) Call 21-Jan-11 18,412,764 3% 41.81 72.50 Settlement 952 30-Dec-09 - 72.50 952 OMXS30 800 (5,000) Put 21-Jan-11 15,731,001 2% 14.04 45.50 Settlement 952 30-Dec-09 - 45.50 952 ODAX 4,500 (20,000) Put 19-Mar-10 15,086,773 2% 1.40 16.00 Settlement 5,971 29-Dec-09 1 14.30 6,022 ODAX 5,600 (3,250) Put 18-Jun-10 13,318,895 2% 163.50 241.40 Settlement 5,971 23-Dec-09 5 253.70 5,960 ODAX 5,200 (3,000) Put 18-Jun-10 13,115,834 2% 62.00 146.00 Settlement 5,971 30-Dec-09 - 146.00 5,971 OMXS30 880 (29,000) Call 22-Jan-10 12,617,521 2% 73.15 77.50 Settlement 952 30-Dec-09 - 77.50 952 ODAX 6,400 (18,250) Call 18-Jun-10 12,434,480 2% 164.70 176.60 Settlement 5,971 30-Dec-09 - 176.60 5,971 Total Navigant Edge for Missvalued Positions 772,664,158 113%

HQ Bank Theor. Price



Contract

Price of Underlying

% of Total

Navigant EdgeUnderlying Position

Call / Put

Expiration Date

Last Price

Navigant Edge

Market Price Used

StrikePrice of

Underlying

Trading Days

from Vol. Review

Trade Date

Page 69

Table 24 – Losses Associated with the 18 Incorrectly Valued Positions136

150. As of 30 December 2009, the Bank reported an aggregate Navigant Edge (difference between

theoretical value and market value) associated with these 18 positions of SEK 773 million and an

aggregate theoretical gain (difference between the amount invested and the theoretical value) of SEK 502

million. This indicates that the Navigant Edge explains the entire theoretical gain and that if the Bank had

used quoted prices or recent transaction prices, there would be a theoretical loss as of 30 December 2009

of SEK 270 million.

151. By the time the bank exited the positions held as of 30 December 2009, the market had moved in

favor of HQ Bank. Consequently, the results associated with these 18 positions had increased from

aggregate losses of SEK 270 million as of 30 December 2009 to aggregate gains of SEK 9 million.137

However, the initial aggregate theoretical gains reported by the Bank as of 30 December 2009 of SEK

502 million never materialized and instead the bank only incurred gains of SEK 9 million from these 18

136 Navigant Edge Database, (NAV-23); HQ Bank Daily Volatility Reviews, (NAV-17). In respect of some of the positions, HQ

Bank has taken new positions in the same instruments. In those instances, the actual result has been calculated based on the most favorable prices that HQ Bank has received for such instruments upon settlement. For the calculation of HQ Bank realized results, see Appendix 5.

137 The aggregate theoretical losses of SEK 453 million reflect movement in the underlying index and changes in the cumulative position for each of the top 18 positions in Table 24 after 30 December 2009.

Underlying Strike Position Call / PutExpiration

DateInvested Amount

Navigant Market Value

Navigant Results

HQ Bank Theoretical

Value

HQ Bank Theoretical

ResultsNavigant

EdgeExit

PeriodActual

Results

ODAX 4,800 (30,000) Put 18-Jun-10 (280) (135) 145 (26) 254 109 Q1 2010 173 ODAX 6,200 (60,000) Call 18-Jun-10 (647) (800) (153) (706) (59) 94 Q1 2010 250 ODAX 5,600 (21,750) Call 18-Jun-10 (406) (686) (280) (595) (189) 90 Q2 2010 (270) ODAX 4,850 (24,000) Put 18-Jun-10 (227) (116) 111 (25) 201 90 Q2 2010 205 ODAX 6,200 31,000 Call 19-Mar-10 241 207 (34) 288 47 81 Q1 2010 (185) ODAX 7,000 114,200 Call 18-Jun-10 296 255 (41) 313 18 59 Q2 2010 (235) ODAX 6,000 (8,000) Call 17-Dec-10 (226) (233) (7) (191) 35 42 Q1 2010 106 ODAX 5,800 27,500 Call 19-Mar-10 401 484 84 516 115 31 Q1 2010 (119) ODAX 4,700 (32,000) Put 19-Mar-10 (168) (38) 130 (7) 161 31 Q1 2010 143

OMXS30 900 (7,000) Put 21-Jan-11 (100) (54) 46 (31) 69 23 Q2 2010 57 ODAX 8,200 36,000 Call 17-Dec-10 39 39 (1) 61 22 22 Q1 2010 (21)

OMXS30 1,000 (6,000) Call 21-Jan-11 (25) (44) (18) (25) 0 18 Q2 2010 (37) OMXS30 800 (5,000) Put 21-Jan-11 (92) (23) 69 (7) 85 16 Q2 2010 75 ODAX 4,500 (20,000) Put 19-Mar-10 (50) (17) 34 (1) 49 15 Q1 2010 39 ODAX 5,600 (3,250) Put 18-Jun-10 62 (41) (103) (27) (89) 13 Q1 2010 (26) ODAX 5,200 (3,000) Put 18-Jun-10 (6) (23) (17) (10) (3) 13 Q1 2010 (5)

OMXS30 880 (29,000) Call 22-Jan-10 (99) (225) (125) (212) (113) 13 Q1 2010 (108) ODAX 6,400 (18,250) Call 18-Jun-10 (56) (167) (111) (154) (99) 12 Q1 2010 (33)

(1,344) (1,614) (270) (841) 502 773 9

As of 30 December 2009 Actual Results

Page 70

positions (i.e., the value recorded for these positions at year-end 2009 was SEK 493 million higher than

the realized value of these positions after settlement). While movements in the DAX index would factor

into the valuation of these positions, the analysis is essentially consistent with the rolling Edge I discussed

in the prior subsection.

C. Conclusions Regarding the Bank’s Financial Reporting of the Performance of the Trading Portfolio from 2007 to 2010

152. Having reviewed the Bank’s valuation methods as disclosed in their annual report, the positions that

the Bank established in its proprietary trading portfolio in derivative instruments and the valuations the

Bank adopted for those positions, I reach the following nine conclusions.

153. First, the Bank created its own restricted definition of an “active market” by comparing the trading

volume of an instrument to the size of the Bank’s position in that instrument rather than evaluating the

activity of the market for the instrument regardless of the size of the Bank’s position in that instrument.

By this restricted definition the Bank allowed itself to incorrectly use Level 2 or 3 valuation techniques

for many large and risky positions. When the positions are viewed on a net basis, the Bank’s valuations

resulted in the recording of values (and profits) for these instruments that were significantly different than

the fair value of the instruments.

154. Second, according to HQ AB the Bank factored its trading strategy into its valuation methods. The

Bank’s stated trading strategy was to assume that the volatility underlying an instrument would revert to

the historical mean. Incorporating this strategy into the valuation method would mean that the Bank

would value the instrument at the price it hoped the instrument would be worth in the future, rather than

valuing it as of the measurement date. This is clearly wrong. When reviewing the derivative positions, I

identified various positions where the Bank in its valuation of the option contract persistently neglected

the underlying volatility of the option. This resulted in a persistent misvaluation of the option that was

maintained until the option contract approached expiration or the Bank offset the position. This could

arguably be the result of a valuation according to the expressed trading strategy of mean reversion.

However, when I reviewed the theoretical volatility used by the Bank I could not detect any pattern in the

Bank’s choice of volatility based on the historical volatility in the underlying index or the implied

volatility of the ATM options. This indicates that the Bank made its own subjective valuation decisions.

155. Third, the Bank’s valuation methods resulted in an extremely high concentration of Level 3

valuations in the years 2007 through 2009. Compared with other Banks I have analyzed, the high

concentration of Level 3 valuations is a red flag.

Page 71

156. Fourth, the Bank incorrectly adopted material day 1 profits. Indeed, the 11 positions previously

analyzed by the Claimant establish this practice in 2009.138 I also discussed one specific instance in

December 2008 (regarding which I had daily trading data) when the Bank wrongly recorded a material

day 1 profit.139 While the daily trading data was very limited prior to 2008, the significant Edge, the

concentration of Level 3 valuations, and the rolling of the Edge, indicate that the Bank established

material day 1 profits also in 2007 and 2008 using valuation methods not based on observable market

inputs.

157. Fifth, the Bank ignored its own transaction prices in valuing derivative instruments that it already

held. For example, on 16 March 2009 the Bank established a liability position on day 1 for SEK 92.8, but

assigned it a theoretical value of SEK 22.7. On day 3, the Bank increased its position at a price of SEK

90.5, but assigned the entire position a theoretical value of SEK 18.6. The second transaction clearly

proved the Bank’s initial valuation of SEK 22.7 was patently wrong.140 Yet, the Bank ignored this second

transaction in establishing a value for the position that was 75 percent lower than its transaction price.

Even if the Bank could support its use of a valuation technique not based on market inputs for this

position (although I cannot understand how that would be possible), the result of the valuation technique

is ridiculous because it is so grossly different from the purchase price and clearly not in compliance with

IAS 39.

158. Sixth, given the significant difference between the theoretical value often assigned by the Bank to

an instrument and the quoted prices or recent transactions in that same instrument (including its own

transaction prices), the Bank clearly adopted a valuation that is obviously inconsistent with IAS 39’s

definition of fair value. Thus, the Bank plainly did not comply with IAS 39 since the valuation result

does not reflect the valuation standard required by IAS 39, i.e. fair value.

159. Seventh, there was a persistently significant Edge since mid-2007. The Navigant Edge which has

been, calculated conservatively reflects a reasonable estimation of the misvaluation of the Bank’s

138 Review of the Bank’s Eleven Incorrectly Valued Positions as the turn of the Year 2009/2010, (NAV-28) 139 In paras. 122-126 above, I referenced a DAX liability position with a strike price of €5,000 beginning on 19 December 2008

and lasting until the expiration date of 18 December 2009. The initial position taken by the Bank was a liability position in 10,000 call option contracts at a price of €609.60 per contract. However, on 22 December 2008 (the following trading day), the Bank assigned a theoretical price to this contract of €344, a price 43 percent lower than the purchase price.

140 See paras. 112-114.

Page 72

derivative portfolio, and shows that the Bank during the whole review period consistently and

significantly overvalued its trading portfolio.

160. Eighth, the Edge was not only significant in size relative to the carrying value of the portfolio, but

incredibly significant in terms of the overall reported profits of the Bank and the reported trading

profits/losses from derivatives as shown in Table 25 below.

Table 25 – NCI Calculated Edge Compared to the Carrying Value of the Derivative Portfolio, Profits of HQ Bank, and Derivative Trading Profits/Losses141

161. As Table 25 above also reveals, the misvaluation was SEK 332 million in 2007, SEK 496 million in

2008 and SEK 685 million in 2009 and thus it increased significantly each year both in terms of the

carrying value of the portfolio and in terms of the Bank’s reported profits. Indeed, the Navigant Edge was

nearly two times the pre-tax income reported by the Bank in 2008 and nearly four times the pre-tax

income reported by the Bank in 2009. Moreover, the Navigant Edge on average amounted to more than

50 percent of the invested amount of the entire derivatives portfolio at each year-end. The misvaluation

saved the Bank from otherwise reporting a pre-tax loss of almost SEK 200 million in 2008 or SEK 500

million in 2009. The Edge values already in 2007 indicate that the Bank’s valuation methods should have

been rigorously evaluated upon which the misvaluation would have been apparent.

162. Ninth, I understand that the Bank’s auditors believed the losses incurred by the Bank in closing its

proprietary trading portfolio in June 2010 were the result of new positions taken in 2010. My analysis of

the Bank’s trading portfolio show that the losses incurred in 2010 were the result of incorrect valuations

established in 2007, 2008, and especially 2009. My analysis indicates that the Bank rolled over distorted

valuations (which increased the Bank’s reported income) from one position to another and from year to

141 Navigant Edge Database, (NAV-23) ; HQ AB 2007 Annual Report, pp. 38, 56, (NAV-5); HQ AB 2008 Annual Report, pp.

34, 53, 67-68, (NAV-7); HQ AB 2009 Annual Report, pp. 34, 53, 66-68, (NAV-8); The invested amount of the derivatives portfolio in Table 25 above shows an overall net short position. The size of the derivatives portfolio in Table 25 above represents the absolute value of the asset and liability positions rather than the net difference.

(amounts in SEK millions) 2007 % 2008 % 2009 %

Navigant Edge 332 496 685 Invested Amount of the Derivatives Portfolio (633) -52.5% (1,188) -41.8% (996) -68.7%Size of the Derivatives Portfolio 3,155 10.5% 4,778 10.4% 5,580 12.3%Pre-tax Income 405 82.0% 278 178.6% 177 386.8%Trading Income (32) (123) (13)

Year-End

Documents

BEFORE THE Stockholm District Court HQ AB v. Mats Qviberg, …/media/Files/H/Hqab/utredning/hqab... · 2014. 11. 6. · demonstrating competence in the investment valuation and decision-making