HSBC 2005 Annual Report Download - page 252

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
250
(j) Sale and repurchase agreements (including stock lending and borrowing)
When securities are sold subject to a commitment to repurchase them at a predetermined price (‘repos’), they
remain on the balance sheet and a liability is recorded in respect of the consideration received. Securities
purchased under commitments to sell (‘reverse repos’) are not recognised on the balance sheet and the
consideration paid is recorded in ‘Loans and advances to banks’ or ‘Loans and advances to customers’ as
appropriate. The difference between the sale and repurchase price is treated as interest and recognised over the
life of the agreement.
Securities lending and borrowing transactions are generally secured, with collateral taking the form of securities
or cash advanced or received. The transfer of securities to counterparties is not normally reflected on the balance
sheet. Cash collateral advanced or received is recorded as an asset or a liability respectively.
Securities borrowed are not recognised on the balance sheet, unless they are sold to third parties, in which case
the obligation to return the securities is recorded as a trading liability and measured at fair value, and any gains
or losses are included in ‘Net trading income’.
For repos and security lending, if the counterparty has the right to sell or repledge the securities transferred, the
securities are presented separately on the balance sheet from assets that may not be repledged or resold by a
counterparty.
(k) Derivatives and hedge accounting
Derivatives are recognised initially, and are subsequently remeasured, at fair value. Fair values of exchange-
traded derivatives are obtained from quoted market prices. Fair values of OTC derivatives are obtained using
valuation techniques, including discounted cash flow models and option pricing models.
In the normal course of business, the fair value of a derivative on initial recognition is the transaction price (that
is the fair value of the consideration given or received). In certain circumstances, however, the fair value will be
based on other observable current market transactions in the same instrument, without modification or
repackaging, or on a valuation technique whose variables include only data from observable markets, such as
interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognises a
trading gain or loss on inception of the derivative. When unobservable market data have a significant impact on
the valuation of derivatives, the entire initial change in fair value indicated by the valuation model is not
recognised immediately in the income statement but is recognised over the life of the transaction on an
appropriate basis or is recognised in the income statement when the inputs become observable, or when the
transaction matures or is closed out.
Derivatives may be embedded in other financial instruments, for example, a convertible bond with an embedded
conversion option. Embedded derivatives are treated as separate derivatives when their economic characteristics
and risks are not clearly and closely related to those of the host contract; the terms of the embedded derivative
are the same as those of a stand-alone derivative; and the combined contract is not held for trading or designated
at fair value. These embedded derivatives are measured at fair value with changes therein recognised in the
income statement.
Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is
negative. Derivative assets and liabilities arising from different transactions are only offset if the transactions are
with the same counterparty, a legal right of offset exists, and the parties intend to settle the cash flows on a net
basis.
The method of recognising fair value gains and losses depends on whether derivatives are held for trading or are
designated as hedging instruments, and if the latter, the nature of the risks being hedged. All gains and losses
from changes in the fair value of derivatives held for trading are recognised in the income statement. When
derivatives are designated as hedges, HSBC classifies them as either: (i) hedges of the change in fair value of
recognised assets or liabilities or firm commitments (‘fair value hedges’); (ii) hedges of the variability in highly
probable future cash flows attributable to a recognised asset or liability, or a forecast transaction (‘cash flow
hedges’); or (iii) hedges of net investments in a foreign operation (‘net investment hedges’). Hedge accounting is
applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge
provided certain criteria are met.