HSBC 2007 Annual Report Download - page 429

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debt, provided that the debt is not repaid early.
Structured notes issued and certain other hybrid instrument liabilities are included within trading liabilities and are
measured at fair value. The credit spread applied to these instruments is derived from the spreads at which HSBC
issues structured notes. These market spreads are significantly smaller than credit spreads observed for plain vanilla
debt or in the credit default swap markets.
All net positions in non-derivative financial instruments, and all derivative portfolios, are valued at bid or offer prices
as appropriate. Long positions are marked at bid prices; short positions are marked at offer prices.
The fair values of large holdings of non-derivative financial instruments are based on a multiple of the value of a
single instrument, and do not include block adjustments for the size of the holding.
The valuation models used where quoted market prices are not available incorporate certain assumptions that HSBC
anticipates would be used by a market participant to establish fair value. Where HSBC believes that there are
additional considerations not included within the valuation model, appropriate adjustments may be made. Examples
of such adjustments are:
• Credit risk adjustment: an adjustment to reflect the credit worthiness of over-the-counter (‘OTC’) derivative
counterparties.
• Market data/model uncertainty: an adjustment to reflect uncertainties in fair values based on unobservable
market data inputs (for example, as a result of illiquidity) or in areas where the choice of valuation model is
particularly subjective.
• Inception profit (‘day 1 P&L reserves’): for financial instruments valued at inception, on the basis of one or
more significant unobservable inputs, the difference between transaction price and model value (as adjusted) at
inception is not recognised in the consolidated income statement, but is deferred and any unamortised balance is
included as part of the fair value.
Transaction costs are not included in the fair value calculation. Trade origination costs such as brokerage fees and
post-trade costs are included in operating expenses. The future costs of administering the OTC derivative portfolio
are also not included in fair value, but are expensed as incurred.
• Loans
Loans are valued from broker quotes and/or market data consensus providers where available. Where
unavailable, fair value will be determined based on an appropriate credit spread derived from other market
instruments issued by the same or comparable entities.
• Debt securities, treasury and other eligible bills, and equities
These instruments are valued based on quoted market prices from an exchange, dealer, broker, industry group
or pricing service, where available. Where unavailable, fair value is determined by reference to quoted market
prices for similar instruments or, in the case of certain mortgage-backed securities and unquoted equities,
valuation techniques using inputs derived from observable market data, and, where relevant, assumptions in
respect of unobservable inputs.
• Derivatives
Over-the-counter (i.e. non-exchange traded) derivatives are valued using valuation models. Valuation models
calculate the present value of expected future cash flows, based upon ‘no-arbitrage’ principles. For many vanilla
derivative products, such as interest rate swaps and European options, the modelling approaches used are
standard across the industry. For more complex derivative products, there may be some discrepancy in practice.
Inputs to valuation models are determined from observable market data wherever possible, including prices
available from exchanges, dealers, brokers or providers of consensus pricing. Certain inputs may not be
observable in the market directly, but can be determined from observable prices via model calibration
procedures. Finally, some inputs are not observable, but can generally be estimated from historic data or other
sources. Examples of inputs that are generally observable include foreign exchange spot and forward rates,
benchmark interest rate curves and volatility surfaces for commonly traded option products. Examples of inputs
that may be unobservable include volatility surfaces, in whole or in part, for less commonly traded option
products, and correlations between market factors.