HSBC 2006 Annual Report Download - page 409

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Net investment hedge
− Hedges of net investments in foreign operations are accounted for in a similar way to cash flow hedges. A
gain or loss on the effective portion of the hedging instrument is recognised in equity; a gain or loss on the
ineffective portion is recognised immediately in the income statement. Gains and losses accumulated in
equity are included in the income statement on the disposal of the foreign operation.
Hedge effectiveness testing
− To qualify for hedge accounting, IAS 39 requires that at inception of the hedge and throughout its life, each
hedge must be expected to be highly effective (prospective effectiveness), and demonstrate actual
effectiveness (retrospective effectiveness) on an ongoing basis.
− The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. The
method HSBC entities adopt for assessing hedge effectiveness will depend on their risk management
strategies.
− For prospective effectiveness, the hedging instrument must be expected to be highly effective in offsetting
changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is
designated. For actual effectiveness to be achieved, the changes in fair value or cash flows must offset each
other in the range of 80 per cent to 125 per cent for the hedge to be deemed effective.
Derivatives that do not qualify for hedge accounting
− All gains and losses from changes in the fair value of derivatives that do not qualify for hedge accounting
are recognised immediately in the income statement. These gains and losses are reported in ‘Net trading
income’, except where derivatives are managed in conjunction with financial instruments designated at fair
value, in which case gains and losses are reported in ‘Net income from financial instruments designated at
fair value’, other than interest settlements on derivatives managed in conjunction with issued debt securities
designed at fair value which are reported in ‘Interest expense’. All other gains and losses on these
derivatives are reported in ‘Net income from financial instruments designated at fair value’.
From 1 January 2004 to 31 December 2004
• Derivative financial instruments comprised futures, forward, swap and option transactions undertaken by HSBC
in the foreign exchange, interest rate, equity, credit derivative, and commodity markets that were held off
balance sheet. Netting was applied where a legal right of set-off existed.
• Accounting for these instruments was dependent upon whether the transactions were undertaken for trading or
non-trading purposes.
Trading transactions
• Trading transactions included transactions undertaken for market-making, to service customers’ needs and for
proprietary purposes, as well as any related hedges.
• Transactions undertaken for trading purposes were marked to market and the net present value of any gain or
loss arising was recognised in the income statement as ‘Net trading income’, after appropriate deferrals for
unearned credit margins and future servicing costs. Derivative trading transactions were valued by reference to
an independent liquid price where this was available. For those transactions with no readily available quoted
prices, predominantly over the counter transactions, market values were determined by reference to
independently sourced rates, using valuation models. If market observable data was not available, the initial
increase in fair value indicated by the valuation model, but based on unobservable inputs, was not recognised
immediately in the income statement. This amount was held back and recognised over the life of the transaction
where appropriate, or released to the income statement when the inputs became observable, or when the
transaction matured or was closed out. Adjustments were made for illiquid positions when appropriate.
• Assets, including gains, resulting from derivative exchange rate, interest rate, equities, credit derivative and
commodity contracts which were marked to market were included in ‘Derivatives’ on the asset side of the
balance sheet. Liabilities, including losses, resulting from such contracts, were included in ‘Derivatives’ on the
liability side of the balance sheet.