HSBC 2003 Annual Report Download - page 304

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
302
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.
Equity swaps are bilateral agreements to transfer the risk and returns on an equity in exchange for a stream
of payments, typically interest.
Credit contracts
Credit default swaps are bilateral agreements to transfer credit risks between counterparties. Under the
agreement, the party buying protection makes one or more payments to the party selling protection during
the life of the swap in exchange for an undertaking by the seller to make a payment to the buyer following a
credit event.
Commodity contracts
Commodity derivatives include exchange traded and over the counter contracts involving commodities
and base metals.
(ii) 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, takes positions in the market and 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.
(iii) 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 Corporate, Investment
Banking and Markets operation, in combination with market risks arising from on-balance-sheet
instruments (Note 40).