HSBC 2004 Annual Report Download - page 301

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37 Financial instruments
(a) Derivatives
Derivatives are financial instruments that derive their value from the price of an underlying item such as equities,
bonds, interest rates, foreign exchange, credit spreads, commodities or equity and other indices.
(i) Types of derivatives
Derivative instruments are classified as being for either trading or hedging purposes. The following outlines
the nature and terms of the most common types of derivatives used by HSBC.
Currency forwards represent commitments to purchase foreign or domestic currency at a future date.
Forward rate agreements are individually negotiated interest rate futures that call for a cash settlement at a
future date for the difference between a contractual rate or agreed rate of interest, and the current market
rate, based on a notional principal amount.
Currency and interest rate swaps are commitments to exchange one set of cash flows for another. Swaps
result in an economic exchange of currencies or interest rates (for example, fixed rate for floating rate) or a
combination of both of these (i.e. cross-currency interest rate swaps). Except for certain currency swaps, no
exchange of principal takes place.
Equity swaps are bilateral agreements to transfer the risk and returns on an equity in exchange for a stream
of payments, typically interest.
Foreign currency, equity and interest rate options are contractual agreements under which the seller
(writer) grants the purchaser (holder) the right, but not the obligation, either to buy (a call option) or sell (a
put option) at or by a set date or during a set period, a specific amount of a foreign currency or a financial
instrument at a predetermined price. In consideration for the assumption of foreign exchange, equity, or
interest rate risk, the seller receives a premium from the purchaser. Options may be either exchange-traded
or negotiated between the Group and a customer on an over the counter basis.
Futures are exchange-traded agreements to buy or sell a standard quantity of a specified fixed income
security, time deposit, equity or currency at a future date, at a price decided at the time the contract is made.
Equity futures may be settled in cash or through delivery.
Credit default swaps are bilateral agreements to transfer credit risks between counterparties. Under the
agreement, the party buying protection makes one or more payments to the party selling protection during
the life of the swap in exchange for an undertaking by the seller to make a payment to the buyer following a
specified credit event. Credit default swaps may be on a single name (counterparty) or may be on multiple
names (counterparties).
Commodity derivatives include exchange traded and over the counter contracts involving commodities and
base metals.
(ii) Use of derivatives
Commercially HSBC transacts in derivatives for three primary purposes – to create risk management
solutions for clients, for proprietary trading purposes, and to manage and hedge HSBC’ s own risks.
For accounting purposes, derivative instruments are classified as either trading or hedging.
Trading Derivatives
Most of the Group’ s derivative transactions relate to sales and trading activities. Sales activities include the
structuring and marketing of derivative products to customers to enable them to take, transfer, modify or
reduce current or expected risks. Trading activities in derivatives are entered into principally for the purpose
of generating profits from short-term fluctuations in price or margin. Positions may be traded actively or be
held over a period of time, to benefit from expected changes in currency rates, interest rates, equity prices or
other market parameters. Trading includes market-making, positioning and arbitrage activities: market-
making involves quoting bid and offer prices to other market participants with the intention of generating
revenues based on spread and volume; positioning means managing market risk positions with the