HSBC 2001 Annual Report Download - page 223

221
Forward rate agreements give the buyer the ability to determine the underlying rate of interest for a specified
period commencing on a specified future date (the ‘settlement date’ ). There is no exchange of principal and
settlement is effected on the settlement date. The settlement amount is calculated by reference to the difference
between the contract rate and the market rate prevailing on the settlement date.
Interest rate options give the buyer on payment of a premium the right, but not the obligation, to fix the rate of
interest on a future deposit or loan, for a specified period and commencing on a specified future date.
Interest rate caps and floors give the buyer the ability to fix the maximum or minimum rate of interest. There
is no facility to deposit or draw down funds; instead the writer pays to the buyer the amount by which the
market rate exceeds or is less than the cap rate or the floor rate respectively. A combination of an interest rate
cap and floor is known as an interest rate collar.
Equities contracts
Equities options give the buyer on payment of a premium the right, but not the obligation, to buy or sell a
specified amount of equities or a basket of equities in the form of published indices.
Equities futures are typically exchange-traded agreements to buy or sell a standard quantity of a specific equity
at a future date, at a price decided at the time the contract is made, and may be settled in cash or through
delivery.
Credit derivatives
In addition to the above, HSBC selectively uses credit derivative contracts. Credit derivatives are off-balance-
sheet financial instruments that typically permit one party to transfer the credit risk of a reference asset to
another party without actually selling the asset. Credit derivative contracts are included in the following tables
within ‘other contracts’ .
Uses of derivatives
Users of derivatives typically want to convert an unwanted risk generated by their business to a more acceptable
risk, or cash. Derivatives provide an effective tool for companies to manage the financial risks associated with
their business and, as a consequence, there has been a significant growth in derivatives transactions in recent
years.
HSBC, through the dealing operations of its subsidiaries, acts as an intermediary between a broad range of
users, structuring deals to produce risk management products to suit individual customer needs. As a result,
HSBC can accumulate significant open positions in derivatives portfolios. These positions are managed
constantly to ensure that they are within acceptable risk levels, with offsetting deals being undertaken to achieve
this where necessary. As well as acting as a dealer, HSBC also uses derivatives (principally interest rate swaps)
in the management of its own asset and liability portfolios and structural positions.
Risks associated with derivatives
Derivative instruments are subject to both market risk and credit risk.
Market risk
The market risk associated with derivatives can be significant since large positions can be accumulated with a
substantially smaller initial outlay than required in cash markets. Recognising this, only certain offices within
major subsidiaries with sufficient derivative product expertise and appropriate control systems are authorised to
trade derivative products. The management of market risk arising from derivatives business is monitored by
Traded Markets Development and Risk, an independent unit within the Investment Banking and Markets
operation, in combination with market risks arising from on-balance-sheet instruments (Note 40).