HSBC 2011 Annual Report Download - page 203

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Overview Operating & Financial Review Corporate Governance Financial Statements Shareholder Information
Structural foreign exchange exposures
(Unaudited)
Structural foreign exchange exposures represent net investments in subsidiaries, branches and associates, the
functional currencies of which are currencies other than the US dollar. An entity’s functional currency is that of
the primary economic environment in which the entity operates.
Exchange differences on structural exposures are recognised in other comprehensive income. We use the US dollar
as our presentation currency in our consolidated financial statements because the US dollar and currencies linked
to it form the major currency bloc in which we transact and fund our business. Our consolidated balance sheet is,
therefore, affected by exchange differences between the US dollar and all the non-US dollar functional currencies
of underlying subsidiaries.
We hedge structural foreign exchange exposures only in limited circumstances. Our structural foreign exchange
exposures are managed with the primary objective of ensuring, where practical, that our consolidated capital ratios
and the capital ratios of individual banking subsidiaries are largely protected from the effect of changes in exchange
rates. This is usually achieved by ensuring that, for each subsidiary bank, the ratio of structural exposures in a given
currency to risk-weighted assets denominated in that currency is broadly equal to the capital ratio of the subsidiary in
question.
We may also transact hedges where a currency in which we have structural exposures is considered to be
significantly overvalued and it is possible in practice to transact a hedge. Any hedging is undertaken using forward
foreign exchange contracts which are accounted for under IFRSs as hedges of a net investment in a foreign operation,
or by financing with borrowings in the same currencies as the functional currencies involved.
Sensitivity of net interest income
(Unaudited)
A principal part of our management of market risk in non-trading portfolios is to monitor the sensitivity of projected
net interest income under varying interest rate scenarios (simulation modelling). We aim, through our management
of market risk in non-trading portfolios, to mitigate the effect of prospective interest rate movements which could
reduce future net interest income, while balancing the cost of such hedging activities on the current net revenue
stream.
For simulation modelling, entities use a combination of scenarios relevant to their local businesses and markets and
standard scenarios which are required throughout HSBC. The latter are consolidated to illustrate the combined pro
forma effect on our consolidated portfolio valuations and net interest income.
Projected net interest income sensitivity figures represent the effect of the pro forma movements in net interest
income based on the projected yield curve scenarios and the Group’s current interest rate risk profile. This effect,
however, does not incorporate actions which would probably be taken by Global Markets or in the business units to
mitigate the effect of interest rate risk. In reality, Global Markets seeks proactively to change the interest rate risk
profile to minimise losses and optimise net revenues. The projections also assume that interest rates of all maturities
move by the same amount (although rates are not assumed to become negative in the falling rates scenario) and,
therefore, do not reflect the potential impact on net interest income of some rates changing while others remain
unchanged. In addition, the projections take account of the effect on net interest income of anticipated differences in
changes between interbank interest rates and interest rates linked to other bases (such as Central Bank rates or
product rates over which the entity has discretion in terms of the timing and extent of rate changes). The projections
make other simplifying assumptions, including that all positions run to maturity.
Projecting the movement in net interest income from prospective changes in interest rates is a complex interaction of
structural and managed exposures. Our exposure to the effect of movements in interest rates on our net interest
income arises in two main areas: core deposit franchises and Balance Sheet Management.
• core deposit franchises are exposed to changes in the cost of deposits raised and spreads on wholesale funds. The
net interest income benefit of core deposits increases as interest rates rise and decreases as interest rates fall. This
risk is asymmetrical in a very low interest rate environment, however, as there is limited room to lower deposit
pricing in the event of interest rate reductions; and
• residual interest rate risk is managed within Balance Sheet Management under our policy of transferring interest
rate risk to it to be managed within defined limits and with flexibility as to the instruments used.