HSBC 2006 Annual Report Download - page 355

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HSBC’s relevant counterparties default at the same time, and that transactions can be replaced instantaneously.
Liability values represent the cost to HSBC’s counterparties of replacing all their transactions with HSBC with a fair
value in their favour if HSBC were to default. Derivative assets and liabilities on different transactions are only set
off if the transactions are with the same counterparty, a legal right of set-off exists and the cash flows are intended to
be settled on a net basis.
Use of derivatives
HSBC transacts derivatives for three primary purposes: to create risk management solutions for clients, for
proprietary trading purposes, and to manage and hedge HSBC’s own risks. Derivatives (except for derivatives which
are designated as effective hedging instruments as defined in IAS 39) are held for trading. The held for trading
classification includes two types of derivatives: those used in sales and trading activities, and those used for risk
management purposes but which for various reasons do not meet the qualifying criteria for hedge accounting. The
second category includes derivatives managed in conjunction with financial instruments designated at fair value.
These activities are described more fully below.
HSBC’s derivative activities give rise to significant open positions in portfolios of derivatives. These positions are
managed constantly to ensure that they remain within acceptable risk levels, with matching deals being utilised to
achieve this where necessary. When entering into derivative transactions, HSBC employs the same credit risk
management procedures to assess and approve potential credit exposures that are used for traditional lending.
Trading derivatives
Most of HSBC’s derivative transactions relate to sales and trading activities. Sales activities include the structuring
and marketing of derivative products to customers to enable them to take, transfer, modify or reduce current or
expected risks. Trading activities in derivatives are entered into principally for the purpose of generating profits from
short-term fluctuations in price or margin. Positions may be traded actively or be held over a period of time to benefit
from expected changes in exchange rates, interest rates, equity prices or other market parameters. Trading includes
market-making, positioning and arbitrage activities. Market-making entails quoting bid and offer prices to other
market participants for the purpose of generating revenues based on spread and volume; positioning means managing
market risk positions in the expectation of benefiting from favourable movements in prices, rates or indices; arbitrage
involves identifying and profiting from price differentials between markets and products.
As mentioned above, other derivatives classified as held for trading include non-qualifying hedging derivatives,
ineffective hedging derivatives and the components of hedging derivatives that are excluded from assessing hedge
effectiveness. Non-qualifying hedging derivatives are entered into for risk management purposes but do not meet the
criteria for hedge accounting. These include derivatives managed in conjunction with financial instruments
designated at fair value.
Gains and losses from changes in the fair value of derivatives that do not qualify for hedge accounting are reported in
‘Net trading income’, except for derivatives managed in conjunction with financial instruments designated at fair
value, where gains and losses are reported in ‘Net income from financial instruments designated at fair value’,
together with the gains and losses on the hedged items. Changes in the fair values of trading derivatives are inclusive
of contractual interest. Changes in the fair value of derivatives managed in conjunction with financial instruments
designated at fair value are included in ‘Net income from financial instruments designated at fair value’ inclusive of
contractual interest unless the derivatives are managed with debt securities in issue, in which case the contractual
interest is shown in interest payable with the interest payable on the issued debt. Substantially all of HSBC Holdings’
derivatives entered into with HSBC undertakings are managed in conjunction with financial liabilities designated at
fair value.