HSBC 2007 Annual Report Download - page 254

HSBC HOLDINGS PLC
Report of the Directors: The Management of Risk (continued)
Market risk > Trading portfolios / Non-trading portfolios
252
The stress scenarios cover a range of potential
market events, such as the hypothetical breaking of a
currency peg or the historical observation of market
moves during previous periods of stress which
would not be captured within VAR. The scenarios
provide senior management with an assessment of
the financial impact such events would have on the
profit and loss of HSBC. The daily losses
experienced during 2007 were within the stress loss
scenarios reported to senior management.
Certain transactions are structured such that the
risk to HSBC is negligible under a wide range of
market conditions or events, but in which there
exists a remote probability that a significant gap
event could lead to loss. A gap event could be seen
as a change in market price from one level to another
with no trading opportunity in between, and where
the price change breaches the threshold beyond
which the risk profile changes from having no open
risk to having full exposure to the underlying
structure. Such movements may occur, for example,
when there are adverse news announcements and the
market for a specific investment becomes illiquid,
making hedging impossible.
Given the characteristics of these transactions,
they will make little or no contribution to VAR or to
traditional market risk sensitivity measures. HSBC
captures the risks for such transactions within the
stress testing scenarios. Gap risk arising is monitored
on an ongoing basis, and HSBC incurred no gap
losses on such transactions in 2007.
Non-trading portfolios
(Audited)
The principal objective of market risk management
of non-trading portfolios is to optimise net interest
income.
Market risk in non-trading portfolios arises
principally from mismatches between the future
yield on assets and their funding cost, as a result
of interest rate changes. Analysis of this risk is
complicated by having to make assumptions on
embedded optionality within certain product areas
such as the incidence of mortgage prepayments,
and from behavioural assumptions regarding the
economic duration of liabilities which are
contractually repayable on demand such as current
accounts. The prospective change in future net
interest income from non-trading portfolios will be
reflected in the current realisable value of these
positions, should they be sold or closed prior to
maturity. In order to manage this risk optimally,
market risk in non-trading portfolios is transferred to
Global Markets or to separate books managed under
the supervision of the local ALCO.
The transfer of market risk to books managed by
Global Markets or supervised by ALCO is usually
achieved by a series of internal deals between the
business units and these books. When the
behavioural characteristics of a product differ from
its contractual characteristics, the behavioural
characteristics are assessed to determine the true
underlying interest rate risk. Local ALCOs are
required to regularly monitor all such behavioural
assumptions and interest rate risk positions to ensure
they comply with interest rate risk limits established
by the Group Management Board.
In certain cases, the non-linear characteristics of
products cannot be adequately captured by the risk
transfer process. For example, both the flow from
customer deposit accounts to alternative investment
products and the precise prepayment speeds of
mortgages will vary at different interest rate levels,
and where expectations about future moves in
interest rates change. In such circumstances,
simulation modelling is used to identify the impact
of varying scenarios on valuations and net interest
income.
Once market risk has been consolidated in
Global Markets or ALCO-managed books, the net
exposure is typically managed through the use of
interest rate swaps within agreed limits. The VAR for
these portfolios is included within the Group VAR
(see ‘Value at risk’ above).
Fixed-rate securities
(Audited)
Market risk also arises on fixed-rate securities issued
by HSBC Holdings. These securities are managed as
capital instruments and include non-cumulative
preference shares, non-cumulative perpetual
preferred securities and fixed-rate subordinated debt.
The interest rate VAR for these capital instruments,
which is not included within Group VAR, was as
follows: