HSBC 2003 Annual Report Download - page 305

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Credit risk
Unlike assets recorded on the balance sheet, where the credit risk is typically the full amount of the
principal value, together with any unrealised interest accrued or mark-to-market gain (Note 14), the credit
risk relative to a derivative is principally the replacement cost of any contract with a positive mark-to-
market gain and an estimate of the potential future change in value, reflecting the volatilities affecting the
contract. Credit risk on contracts having a negative mark-to-market value is restricted to the potential future
change in value. Credit risk on derivatives is, therefore, small in relation to a comparable balance sheet risk.
In addition, credit exposure with individual counterparties can be reduced by the receipt of collateral and
close-out netting agreements which allow for positive and negative mark-to-market values on different
transactions to be offset and settled by a single payment in the event of default by either party. Such
agreements are enforceable in the jurisdictions of the major market makers and HSBC has executed close-
out netting agreements with the majority of its significant counterparties, notwithstanding the fact that
HSBC deals only with the most creditworthy counterparties.
The credit risk profile generated by the use of credit derivatives has an additional dimension. Where HSBC
purchases protection, credit risk arises through the cost of replacing the contract as set out above and it is
managed and reduced in the same way as for other derivative contracts. Selling protection through credit
derivatives gives rise to additional credit risk. This credit risk arises as a direct consequence of the
obligation of HSBC as the protection seller to make a payment to the protection buyer following a credit
event on a reference name. HSBC manages the credit risk with regards to reference names by including any
such exposures arising from credit derivatives within its overall credit limits structure. In addition the
trading of credit derivatives is restricted to a small number of offices within the major centres which in
management’ s view have the control infrastructure and market skills to effectively manage the credit risk
inherent in the products.
(iv) Derivatives used for trading purposes
The following tables summarise the contract amount, replacement cost, mark-to-market values and average
mark-to-market values of third party and internal trading derivatives by product type. The replacement cost
shown is the positive mark-to-market value and represents the accounting loss HSBC would incur if the
counterparty to a derivative contract failed to perform according to the terms of the contract and the
collateral, if any, for the amount due proved to be of no value.
The notional or contractual amounts of these instruments indicate the volume of transactions outstanding at
the balance sheet date; they do not represent amounts at risk.
Because all derivative instruments used for trading purposes are marked to market, carrying values are
equal to mark-to-market values. Mark-to-market values are determined by reference to market rates
prevailing on the date of valuation or by discounting future cash flows and include netted internal positions,
except where otherwise indicated.