HSBC 2004 Annual Report Download - page 304

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
302
The table below summarises the carrying value and mark-to-market value of derivative contracts held for
risk management purposes. Mark-to-market values for assets and liabilities arising from derivatives held for
non-trading purposes are determined in the same way as those set out for trading derivatives above,
including internal positions.
2004 2003
Carrying
value
Mark-to-
market values
Carrying
value
Mark-to-
market values
US$m US$m US$m US$m
Exchange rate assets ..................... 6,282 6,366 3,658 4,297
liabilities................ (3,488) (3,204) (3,147) (3,495)
Interest rate assets ..................... 2,335 4,638 1,824 5,814
liabilities................ (2,525) (3,117) (2,312) (4,136)
Equities assets ..................... ––459
(iii) Risks associated with derivatives
Derivative instruments are subject to both market risk and credit risk.
Market risk
The Group takes on exposure to market risk. Market risk arises from open positions in interest rate, currency
and equity products, all of which are exposed to general and specific market movements. The Group applies
a ‘value at risk’ methodology to calculate the market risk of positions held and the maximum losses
expected, based upon a number of assumptions for various changes in market conditions.
The market risk associated with derivatives can be significant since large positions can be accumulated with
a substantially smaller initial outlay than required in cash markets. Recognising this, only certain offices
within major subsidiaries with sufficient derivative product expertise and appropriate control systems are
authorised to trade derivative products. Market risk arising from derivatives business, as well as the market
risk arising from on-balance-sheet instruments is monitored by Traded Markets Development and Risk, an
independent unit within the Corporate, Investment Banking and Markets operation.
Credit risk
Unlike assets recorded on the balance sheet, where the credit risk is typically the full amount of the principal
value, together with any unrealised interest accrued or mark-to-market gain, the credit risk of a derivative is
principally the replacement cost of any contract with a positive mark-to-market gain and an estimate of the
potential future change in value, reflecting the volatilities affecting the contract.
The credit risk on contracts having a negative mark-to-market value is restricted to the potential future
change in value. Credit risk on derivatives is, therefore, small in relation to an equivalent on-balance sheet
risk. In addition, credit exposure with individual counterparties can be reduced by the receipt of collateral
and close-out netting agreements which allow for positive and negative mark-to-market values on different
transactions to be offset and settled by a single payment in the event of default by either party. Such
agreements are enforceable in the jurisdictions of the major markets in which the Group operates and HSBC
has executed closeout netting agreements with the majority of its significant counterparties. Furthermore
HSBC transacts derivatives with only creditworthy counterparties.
The credit risk profile generated by the use of credit derivatives has an additional dimension. Where HSBC
purchases protection, credit risk arises through the cost of replacing the contract as set out above and it is
managed and reduced in the same way as for other derivative contracts. Selling protection through credit
derivatives gives rise to additional credit risk. This credit risk arises as a direct consequence of the
obligation of HSBC as the protection seller to make a payment to the protection buyer following a credit
event on a reference name. HSBC manages the credit risk with regard to reference names by including any
such exposures arising from credit derivatives within its overall credit limits structure. In addition the
trading of credit derivatives is restricted to a small number of offices within the major centres which in
management’ s view have the control infrastructure and market skills to manage effectively the credit risk
inherent in the products.