HSBC 2008 Annual Report Download - page 166

HSBC HOLDINGS PLC
Report of the Directors: Impact of Market Turmoil (continued)
Fair values of financial instruments > Carried at fair value
164
prices in an inactive market for the instrument, or are
estimated by comparison with quoted prices in an
active market for similar instruments. In both cases,
the fair value includes the effect of applying the
credit spread which is appropriate to HSBC’s
liabilities. For all issued debt securities, discounted
cash flow modelling is used to separate the change in
fair value that may be attributed to HSBC’s credit
spread movements from movements in other market
factors such as benchmark interest rates or foreign
exchange rates. Specifically, the change in fair value
of issued debt securities attributable to the Group’s
own credit spread is computed as follows: for each
security at each reporting date, an externally
verifiable price is obtained or a price is derived using
credit spreads for similar securities for the same
issuer. Then, using discounted cash flow, each
security is valued using a risk-free discount curve.
The difference in the valuations is attributable to the
Group’s own credit spread. This methodology is
applied consistently across all securities.
Structured notes issued and certain other hybrid
instrument liabilities are included within trading
liabilities and are measured at fair value. The credit
spread applied to these instruments is derived from
the spreads at which HSBC issues structured notes.
These market spreads are significantly smaller than
credit spreads observed for plain vanilla debt or in
the credit default swap markets.
Gains and losses arising from changes in the
credit spread of liabilities issued by HSBC reverse
over the contractual life of the debt, provided that the
debt is not repaid early.
All net positions in non-derivative financial
instruments, and all derivative portfolios, are valued
at bid or offer prices as appropriate. Long positions
are marked at bid prices; short positions are marked
at offer prices.
The fair value of a portfolio of financial
instruments quoted in an active market is calculated
as the product of the number of units and its quoted
price and no block discounts are made.
The valuation techniques used when quoted
market prices are not available incorporate certain
assumptions that HSBC believes would be made
by a market participant to establish fair value.
When HSBC considers that there are additional
considerations not included within the valuation
model, appropriate adjustments may be made.
Examples of such adjustments are:
• Credit risk adjustment: an adjustment to reflect
the creditworthiness of OTC derivative
counterparties.
• Market data/model uncertainty: an adjustment
to reflect uncertainties in fair values based on
unobservable market data inputs (for example,
as a result of illiquidity), or in areas where the
choice of valuation model is particularly
subjective.
• Inception profit (‘day 1 gain or loss’): for
financial instruments valued at inception on the
basis of one or more significant unobservable
inputs, the difference between transaction price
and model value, as adjusted, at inception (the
day 1 gain or loss) is not recognised in the
consolidated income statement, but is deferred.
An analysis of the movement in the deferred
day 1 gain or loss is provided on page 400.
Transaction costs are not included in the fair
value calculation, nor are the future costs of
administering the OTC derivative portfolio. These,
along with trade origination costs such as brokerage
fees and post-trade costs, are included either in fee
expense or in operating expenses.
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 debt securities backed by US sub-
prime mortgages has resulted in less observable