HSBC 2015 Annual Report Download - page 391

HSBC HOLDINGS PLC
389
Strategic Report Financial Review Corporate Governance Financial Statements Shareholder Information
Private equity including strategic investments
Given the bespoke nature of the analysis in respect of each holding, it is not practical to quote a range of key unobservable
inputs.
Prepayment rates
Prepayment rates are a measure of the anticipated future speed at which a loan portfolio will be repaid in advance of the due
date. They are an important input into modelled values of ABSs. A modelled price may be used where insufficient observable
market prices exist to enable a market price to be determined directly. Prepayment rates are also an important input into the
valuation of derivatives linked to securitisations. They vary according to the nature of the loan portfolio and expectations of
future market conditions, and may be estimated using a variety of evidence, such as prepayment rates implied from proxy
observable security prices, current or historical prepayment rates and macroeconomic modelling.
Market proxy
Market proxy pricing may be used for an instrument for which specific market pricing is not available, but evidence is available
in respect of instruments that have some characteristics in common. In some cases it might be possible to identify a specific
proxy, but more generally evidence across a wider range of instruments will be used to understand the factors that influence
current market pricing and the manner of that influence.
The range of prices used as inputs into a market proxy pricing methodology may therefore be wide. This range is not indicative
of the uncertainty associated with the price derived for an individual security.
Volatility
Volatility is a measure of the anticipated future variability of a market price, tending to increase in stressed market conditions
and decrease in calmer market conditions. It is an important input in the pricing of options. In general, the higher the volatility,
the more expensive the option will be. This reflects both the higher probability of an increased return from the option and the
potentially higher costs that HSBC may incur in hedging the risks associated with the option. If option prices become more
expensive, this increases the value of HSBC’s long option positions (i.e. the positions in which HSBC has purchased options),
while HSBC’s short option positions (i.e. the positions in which HSBC has sold options) suffer losses.
Volatility varies by underlying reference market price, and by strike and maturity of the option. Volatility also varies over time.
As a result, it is difficult to make general statements regarding volatility levels.
Certain volatilities, typically those of a longer-dated nature, are unobservable. The unobservable volatility is then estimated
from observable data. The range of unobservable volatilities quoted in the table on page 387 reflects the wide variation in
volatility inputs by reference market price. The core range is significantly narrower than the full range because these examples
with extreme volatilities occur relatively rarely within the HSBC portfolio. For any single unobservable volatility, the
uncertainty in the volatility determination is significantly less than the range quoted above.
Correlation
Correlation is a measure of the inter-relationship between two market prices and is expressed as a number between minus
one and one. A positive correlation implies that the two market prices tend to move in the same direction, with a correlation
of one implying that they always move in the same direction. A negative correlation implies that the two market prices tend
to move in opposite directions, with a correlation of minus one implying that the two market prices always move in opposite
directions. Correlation is used to value more complex instruments where the payout is dependent upon more than one market
price. There is a wide range of instruments for which correlation is an input, and consequently a wide range of both same-asset
correlations (e.g. equity-equity correlation) and cross-asset correlations (e.g. foreign exchange rate-interest rate correlation) is
used. In general, the range of same-asset correlations will be narrower than the range of cross-asset correlations.
Correlation may be unobservable. Unobservable correlations may be estimated based upon a range of evidence, including
consensus pricing services, HSBC trade prices, proxy correlations and examination of historical price relationships.
The range of unobservable correlations quoted in the table reflects the wide variation in correlation inputs by market price
pair. For any single unobservable correlation, the uncertainty in the correlation determination is likely to be less than the range
quoted above.
Credit spread
Credit spread is the premium over a benchmark interest rate required by the market to accept lower credit quality. In
a discounted cash flow model, the credit spread increases the discount factors applied to future cash flows, thereby reducing
the value of an asset. Credit spreads may be implied from market prices. Credit spreads may not be observable in more illiquid
markets.