HSBC 2015 Annual Report Download - page 385

HSBC HOLDINGS PLC
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Strategic Report Financial Review Corporate Governance Financial Statements Shareholder Information
Asset-backed securities
While quoted market prices are generally used to determine the fair value of these securities, valuation models are used to
substantiate the reliability of the limited market data available and to identify whether any adjustments to quoted market
prices are required. For ABSs including residential mortgage-backed securities, the valuation uses an industry standard model
and the assumptions relating to prepayment speeds, default rates and loss severity based on collateral type, and performance,
as appropriate. The valuations output is benchmarked for consistency against observable data for securities of a similar nature.
Loans, including leveraged finance and loans held for securitisation
Loans held at fair value are valued from broker quotes and/or market data consensus providers when available. In the absence
of an observable market, the fair value is determined using alternative valuation techniques. These techniques include
discounted cash flow models, which incorporate assumptions regarding an appropriate credit spread for the loan, derived
from other market instruments issued by the same or comparable entities.
Structured notes
The fair value of structured notes valued using a valuation technique with significant unobservable inputs is derived from the
fair value of the underlying debt security, and the fair value of the embedded derivative is determined as described in the
paragraph below on derivatives.
Level 3 structured notes principally comprise equity-linked notes which are issued by HSBC and provide the counterparty with
a return that is linked to the performance of certain equity securities, and other portfolios. The notes are classified as Level 3
due to the unobservability of parameters such as long-dated equity volatilities and correlations between equity prices,
between equity prices and interest rates and between interest rates and foreign exchange rates.
Derivatives
OTC (i.e. non-exchange traded) derivatives are valued using valuation models. Valuation models calculate the present value of
expected future cash flows, based upon ‘no-arbitrage’ principles. For many vanilla derivative products, such as interest rate
swaps and European options, the modelling approaches used are standard across the industry. For more complex derivative
products, there may be some differences in market practice. Inputs to valuation models are determined from observable
market data wherever possible, including prices available from exchanges, dealers, brokers or providers of consensus pricing.
Certain inputs may not be observable in the market directly, but can be determined from observable prices via model
calibration procedures or estimated from historical data or other sources. Examples of inputs that may be unobservable
include volatility surfaces, in whole or in part, for less commonly traded option products, and correlations between market
factors such as foreign exchange rates, interest rates and equity prices.
Derivative products valued using valuation techniques with significant unobservable inputs include certain types of correlation
products, such as foreign exchange basket options, equity basket options, foreign exchange interest rate hybrid transactions
and long-dated option transactions. Examples of the latter are equity options, interest rate and foreign exchange options and
certain credit derivatives. Credit derivatives include certain tranched CDS transactions.