HSBC 2004 Annual Report Download - page 251

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Trading transactions
Trading transactions include transactions undertaken for market-making, to service customers’ needs and for
proprietary purposes, as well as any related hedges.
Transactions undertaken for trading purposes are marked-to-market and the net present value of any gain or loss
arising is recognised in the profit and loss account as ‘Dealing profits’ , after appropriate deferrals for unearned
credit margin and future servicing costs. Off-balance sheet trading transactions are valued by reference to an
independent liquid price where this is available. For those transactions where there are no readily quoted prices,
which predominantly relates to over the counter transactions, market values are determined by reference to
independently sourced rates, using valuation models. If market observable data are not available, the initial
increase in fair value indicated by the valuation model, but based on unobservable inputs, is not recognised
immediately in the profit and loss account. This amount is held back and recognised over the life of the
transaction where appropriate, or released to the profit and loss account when the inputs become observable, or,
when the transaction matures or is closed out. Adjustments are made for illiquid positions where appropriate.
Assets, including gains, resulting from off-balance sheet exchange rate, interest rate, equities, credit derivative
and commodity contracts which are marked-to-market are included in ‘Other assets’ . Liabilities, including
losses, resulting from such contracts, are included in ‘Other liabilities’ .
Non-trading transactions
Non-trading transactions are those which are held for hedging purposes as part of HSBC’ s risk management
strategy against cashflows, assets, liabilities or positions measured on an accruals basis. Non-trading transactions
include qualifying hedges and positions that synthetically alter the characteristics of specified financial
instruments.
Non-trading transactions are accounted for on an equivalent basis to the underlying assets, liabilities or net
positions. Any gain or loss arising is recognised on the same basis as that arising from the related assets,
liabilities or positions.
To qualify as a hedge, a derivative must effectively reduce the price, foreign exchange or interest rate risk of the
asset, liability or anticipated transaction to which it is linked and be designated as a hedge at inception of the
derivative contract. Accordingly, changes in the market value of the derivative must be highly correlated with
changes in the market value of the underlying hedged item at inception of the hedge and over the life of the
hedge contract. If these criteria are met, the derivative is accounted for on the same basis as the underlying
hedged item. Derivatives used for hedging purposes include swaps, forwards and futures.
Interest rate swaps are also used to alter synthetically the interest rate characteristics of financial instruments. In
order to qualify for synthetic alteration, a derivative instrument must be linked to specific individual, or pools of
similar, assets or liabilities by the notional principal and interest rate risks of the associated instruments, and
must achieve a result that is consistent with defined risk management objectives. If these criteria are met,
accruals based accounting is applied, i.e. income or expense is recognised and accrued to the next settlement
date in accordance with the contractual terms of the agreement.
Any gain or loss arising on the termination of a qualifying derivative is deferred and amortised to earnings over
the original life of the terminated contract. Where the underlying asset, liability or position is sold or terminated,
the qualifying derivative is immediately marked-to-market and any gain or loss arising is taken to the profit and
loss account.
(m) Long-term assurance business
The value placed on HSBC’ s interest in long-term assurance business includes a valuation of the discounted
future earnings expected to emerge from business currently in force, using appropriate assumptions in assessing
factors such as recent experience and general economic conditions, together with the surplus retained in the
long-term assurance funds. These are determined annually, in consultation with external actuaries, and included
in ‘Other assets’ .
Changes in the value placed on HSBC’ s interest in long-term assurance business are calculated on a post-tax
basis and reported gross in the profit and loss account as part of ‘Other operating income’ after adjusting for
taxation.