HSBC 2009 Annual Report Download - page 172

HSBC HOLDINGS PLC
Report of the Directors: Impact of Market Turmoil (continued)
Fair values of financial instruments > Carried at fair value
170
of the unobservable component. The ‘observability
boundary’ is the point at which during the lifetime
of the trade the previously unobservable significant
input is expected to become observable, which at
the extreme may be the maturity date.
An analysis of the movement in the deferred
Day 1 P&L reserve is provided on page 426.
Transaction costs and the future costs of
administering the OTC derivative portfolio are not
included in the fair value calculation. These, along
with trade origination costs such as brokerage fees
and post-trade costs, are accounted for as part of
either fee expense or operating expenses.
Credit risk adjustment methodology
HSBC adopts a credit risk adjustment (also
frequently known as a ‘credit valuation adjustment’)
against OTC derivative transactions to reflect within
fair value the possibility that the counterparty may
default, and HSBC may not receive the full market
value of the transactions. HSBC calculates a separate
credit risk adjustment for each HSBC legal entity,
and within each entity for each counterparty to
which the entity has exposure. The calculation of the
monoline credit risk adjustment is described on
page 163. The description below relates to the credit
risk adjustment taken against counterparties other
than monolines, which totalled US$1,009 million at
31 December 2009 (2008: US$1,492 million).
HSBC calculates the credit risk adjustment
by applying the probability of default of the
counterparty to the expected positive exposure to the
counterparty, and multiplying the result by the
loss expected in the event of default. The calculation
is performed over the life of the potential exposure.
For most products, HSBC uses a simulation
methodology to calculate the expected positive
exposure. The methodology simulates the range of
potential exposures of HSBC to the counterparty
over the life of an instrument. The range of
exposures is calculated across the portfolio of
transactions with a counterparty to arrive at an
expected overall exposure. The probability of default
assumptions are based upon historic rating transition
matrices. The credit rating used for a particular
counterparty is that determined by HSBC’s internal
credit process. Rating transition is taken account of
throughout the duration of the exposure. A standard
loss given default assumption of 60 per cent is
generally adopted. HSBC considers that an
appropriate spread to reflect HSBC’s own probability
of default within the credit risk adjustment
calculation is currently zero. Consequently, HSBC
does not derive the adjustment on a bilateral basis
and has a zero adjustment against derivative
liabilities, often referred to as a ‘debit valuation
adjustment’. The simulation methodology includes
credit mitigants such as counterparty netting
agreements and collateral agreements with the
counterparty.
For certain types of exotic derivatives where
the products are not currently supported by the
simulation, or for derivative exposures in smaller
trading locations where the simulation tool is not yet
available, HSBC adopts an alternative methodology.
Alternative methodologies used by HSBC fall into
two categories. One method maps transactions
against the results for similar products which are
accommodated by the simulation tool. Where such a
mapping approach is not appropriate, a bespoke
methodology is used, generally following the same
principles as the simulation methodology, reflecting
the key characteristics of the instruments but in a
manner that is computationally less intensive. The
calculation is applied at a trade level, with more
limited recognition of credit mitigants such as
netting or collateral agreements than used in the
simulation methodology described previously.
The methodologies do not, in general, account
for ‘wrong-way risk’. Wrong-way risk arises where
the underlying value of the derivative prior to any
credit risk adjustment is related to the probability
of default of the counterparty. A more detailed
description of wrong-way risk is included on
page 208. For particular transactions where there is
significant wrong-way risk, a trade specific approach
is applied to reflect the wrong-way risk within the
valuation.
HSBC includes all third-party counterparties in
the credit risk adjustment calculation and HSBC
does not net credit risk adjustments across HSBC
Group entities.
During 2009, there were no material changes
made by HSBC to the methodologies used to
calculate the credit risk adjustment.
Consideration of other methodologies for
calculation of credit risk adjustments
(Unaudited)
The credit risk adjustment methodology used by
HSBC, in the opinion of management, appropriately
quantifies the exposure of HSBC to counterparty risk
on its OTC derivative portfolio and appropriately
reflects the risk management strategy of the
business.
HSBC recognises that a variety of credit risk
adjustment methodologies are adopted within the