HSBC 2009 Annual Report Download - page 173

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banking industry. Some of the key attributes that
may differ between these methodologies are:
• the probability of default may be calculated
from historical market data, or implied from
current market levels for certain transaction
types such as credit default swaps, either with or
without an adjusting factor;
• some entities derive their own probability of
default from a non-zero spread, which has the
effect of reducing the overall adjustment;
• differing loss assumptions in setting the level of
loss given defaults, which may utilise levels set
by regulators for capital calculation purposes;
and
• counterparty exclusions, whereby certain
counterparty types (for example collateralised
counterparties) are excluded from the
calculation.
HSBC has estimated the impact of adopting two
alternative methodologies on the level of its credit
risk adjustment (excluding the monoline credit risk
adjustment), as follows:
• adapting HSBC’s existing methodology to
utilise probabilities of default implied from
credit default swaps with no adjustment factor
applied and also implying HSBC’s own
probability of default from credit default swaps,
results in an additional adjustment of
US$170 million; and
• adapting HSBC’s existing methodology to
include HSBC’s own probability of default from
a non-zero spread based on historical data,
excluding collateralised counterparties, and
applying loss given default assumptions
consistent with those used in regulatory capital
calculations, results in a reduction of the credit
risk adjustment of US$300 million.
A detailed description of the valuation
techniques applied to instruments of particular
interest follows:
Private equity
HSBC’s private equity positions are generally
classified as available for sale and are not traded in
active markets. In the absence of an active market,
an investment’s fair value is estimated on the basis
of an analysis of the investee’s financial position and
results, risk profile, prospects and other factors, as
well as by reference to market valuations for similar
entities quoted in an active market, or the price at
which similar companies have changed ownership.
The exercise of judgement is required because of
uncertainties inherent in estimating fair value for
private equity investments.
Debt securities, treasury and other eligible bills,
and equities
The fair value of these instruments is based on
quoted market prices from an exchange, dealer,
broker, industry group or pricing service, when
available. When they are unavailable, the fair value
is determined by reference to quoted market prices
for similar instruments, adjusted as appropriate for
the specific circumstances of the instruments.
Illiquidity and a lack of transparency in the
market for ABSs have resulted in less observable
data being available. While quoted market prices are
generally used to determine the fair value of these
securities, valuation models are used to substantiate
the reliability of the limited market data available
and to identify whether any adjustments to quoted
market prices are required.
In the absence of quoted market prices, fair
value is determined using valuation techniques based
on the calculation of the present value of expected
future cash flows of the assets. The inputs to these
valuation techniques are derived from observable
market data and, where relevant, assumptions in
respect of unobservable inputs. In respect of ABSs
including residential MBSs, the valuation uses an
industry standard model and the assumptions relating
to prepayment speeds, default rates and loss severity
based on collateral type, and performance, as
appropriate. The valuations output is benchmarked
for consistency against observable data for securities
of a similar nature.
Derivatives
OTC (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 differences in market 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
historical data or other sources. Examples of inputs