HSBC 2006 Annual Report Download - page 408

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
Note 47
406
• Derivatives may be embedded in other financial instruments; for example, a convertible bond has an embedded
conversion option. An embedded derivative is treated as a separate derivative when its economic characteristics
and risks are not clearly and closely related to those of the host contract, its terms are the same as those of a
stand-alone derivative, and the combined contract is not held for trading or designated at fair value. These
embedded derivatives are measured at fair value with changes in fair value recognised in the income statement.
• Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is
negative. Derivative assets and liabilities arising from different transactions are only netted if the transactions are
with the same counterparty, a legal right of offset exists, and the cash flows are intended to be settled on a net
basis.
• The method of recognising the resulting fair value gains or losses depends on whether the derivative is held for
trading, or is designated as a hedging instrument and, if so, the nature of the risk being hedged. All gains and
losses from changes in the fair value of derivatives held for trading are recognised in the income statement.
When derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value
of recognised assets or liabilities or firm commitments (‘fair value hedge’); (ii) hedges of the variability in highly
probable future cash flows attributable to a recognised asset or liability, or a forecast transaction (‘cash flow
hedge’); or (iii) hedges of net investments in a foreign operation (‘net investment hedge’). Hedge accounting is
applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge
provided certain criteria are met.
Hedge accounting
− It is HSBC’s policy to document, at the inception of a hedge, the relationship between the hedging
instruments and the hedged items, as well as the risk management objective and strategy for undertaking the
hedge. The policy also requires documentation of the assessment, both at hedge inception and on an ongoing
basis, of whether the hedging instruments, primarily derivatives, that are used in the hedging transaction are
highly effective in offsetting changes in fair values or cash flows of hedged items attributable to the hedged
risks. Interest on designated qualifying hedges is included in ‘Net interest income’.
Fair value hedge
− Changes in the fair values of derivatives that are designated and qualify as fair value hedging instruments
are recorded in the income statement, together with changes in the fair values of the hedged assets or
liabilities or groups thereof that are attributable to the hedged risks.
− If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to
the carrying amount of a hedged item is amortised to the income statement based on a recalculated effective
interest rate over the residual period to maturity, unless the hedged item has been derecognised, in which
case it is released to the income statement immediately.
Cash flow hedge
− The effective portion of changes in the fair values of derivatives that are designated and qualify as cash flow
hedges are recognised in equity within the cash flow hedging reserve. Any gain or loss relating to an
ineffective portion is recognised immediately in the income statement.
− Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged
item will affect profit or loss. However, when the forecast transaction that is hedged results in the
recognition of a non-financial asset or a non-financial liability, the gains and losses previously deferred in
equity are transferred from equity and included in the initial measurement of the cost of the asset or liability.
− When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge
accounting, any cumulative gain or loss existing in equity at that time remains in equity until the forecast
transaction is eventually recognised in the income statement. When a forecast transaction is no longer
expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the
income statement.