HSBC 2005 Annual Report Download - page 382

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
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at fair value, in which case gains and losses are reported in ‘Net income from financial instruments
designated at fair value’, other than interest settlements on derivatives used to hedge issues of own debt
which are reported in ‘Interest expense’.
From 1 January 2004 to 31 December 2004
• Derivative financial instruments comprised futures, forward, swap and option transactions undertaken by HSBC
in the foreign exchange, interest rate, equity, credit derivative, and commodity markets that were held off
balance sheet. Netting was applied where a legal right of set-off existed.
• Accounting for these instruments was dependent upon whether the transactions were undertaken for trading or
non-trading purposes.
Trading transactions
• Trading transactions included transactions undertaken for market-making, to service customers’ needs and for
proprietary purposes, as well as any related hedges.
• Transactions undertaken for trading purposes were marked to market and the net present value of any gain or
loss arising was recognised in the income statement as ‘Trading income’, after appropriate deferrals for
unearned credit margins and future servicing costs. Derivative trading transactions were valued by reference to
an independent liquid price where this was available. For those transactions with no readily available quoted
prices, predominantly over the counter transactions, market values were determined by reference to
independently sourced rates, using valuation models. If market observable data was not available, the initial
increase in fair value indicated by the valuation model, but based on unobservable inputs, was not recognised
immediately in the income statement. This amount was held back and recognised over the life of the transaction
where appropriate, or released to the income statement when the inputs became observable, or when the
transaction matured or was closed out. Adjustments were made for illiquid positions when appropriate.
• Assets, including gains, resulting from derivative exchange rate, interest rate, equities, credit derivative and
commodity contracts which were marked to market were included in ‘Derivatives’ on the asset side of the
balance sheet. Liabilities, including losses, resulting from such contracts, were included in ‘Derivatives’ on the
liability side of the balance sheet.
Non-trading transactions
• Non-trading transactions, which were those undertaken for hedging purposes as part of HSBC’s risk
management strategy against cash flows, assets, liabilities or positions, were measured on an accrual basis.
Non-trading transactions included qualifying hedges and positions that synthetically altered the characteristics
of specified financial instruments.
• Non-trading transactions were accounted for on an equivalent basis to the underlying assets, liabilities or net
positions. Any gains or losses arising were recognised on the same basis as those arising from the related assets,
liabilities or positions.
• To qualify as a hedge, a derivative was required effectively to reduce the price, foreign exchange or interest rate
risk of the asset, liability or anticipated transaction to which it was linked and be capable of designation as a
hedge at inception of the derivative contract. Accordingly, changes in the market value of the derivative were
required to be highly correlated to 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 were met, the derivative was accounted for on the
same basis as the underlying hedged item. Derivatives used for hedging purposes included swaps, forwards and
futures. Interest rate swaps were also used to alter synthetically the interest rate characteristics of financial
instruments. In order to qualify for synthetic alteration, a derivative instrument had to 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 had to achieve a result that was consistent with defined risk management objectives.
If these criteria were met, accruals based accounting was applied, i.e. income or expense was 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 was deferred and amortised to earnings
over the original life of the terminated contract. Where the underlying asset, liability or position was sold or