HSBC 2012 Annual Report Download - page 443

441
Overview
Operating & Financial Review
Corporate Governance
Financial Statements
Shareholder Information
Inception profit (Day 1 P&L reserves)
Inception profit adjustments are adopted where the fair value estimated by a valuation model is based on one or more
significant unobservable inputs. The accounting for inception profit adjustments is discussed on page 388. An
analysis of the movement in the deferred Day 1 P&L reserve is provided on page 454.
Credit valuation adjustment/debit valuation adjustment methodology
HSBC calculates a separate credit valuation adjustment (‘CVA’) and debit valuation adjustment (‘DVA’) for each
HSBC legal entity, and within each entity for each counterparty to which the entity has exposure. The calculation of
the monoline CVA is described on page 189.
HSBC calculates the CVA by applying the probability of default (‘PD’) of the counterparty conditional on the non-
default of HSBC, to the expected positive exposure of HSBC to the counterparty, and multiplying the result by the
loss expected in the event of default. Conversely, HSBC calculates the DVA by applying the PD of HSBC,
conditional on the non-default of the counterparty, to the expected positive exposure of the counterparty to HSBC,
and multiplying by the loss expected in the event of default. Both calculations are performed over the life of the
potential exposure.
As set out on page 383, from 31 December 2012 HSBC revised its methodology for estimating the CVA and the
DVA for derivatives. The CVA calculation maximises the use of PD based on relevant, observable market data,
such as credit default swap (‘CDS’) spreads. Where CDS spreads are not available, PDs are estimated having regard
to market practice, considering relevant data including both CDS indices and historical rating transition matrices.
HSBC aligned its methodology for estimating the DVA to be consistent with that applied for the CVA as at
31 December 2012. Historically, HSBC considered that a zero spread was appropriate in respect of own credit
risk and consequently did not adjust derivative liabilities for its own credit risk.
For most products, to calculate the expected positive exposure to a counterparty, HSBC uses a simulation
methodology to incorporate the range of potential exposures across the portfolio of transactions with the counterparty
over the life of an instrument. The simulation methodology includes credit mitigants such as counterparty netting
agreements and collateral agreements with the counterparty. A standard loss given default assumption of 60% is
generally adopted for developed market exposures, and 75% for emerging market exposures. Alternative loss given
default assumptions may be adopted where both the nature of the exposure and the available data support this.
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
alternative methodologies. These may involve mapping to the results for similar products from the simulation tool
or where such a mapping approach is not appropriate, a simplified methodology is used, generally following the same
principles as the simulation methodology. 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 CVA is positively correlated to the probability of default of the counterparty.
Where there is significant wrong-way risk, a trade-specific approach is applied to reflect the wrong-way risk within
the valuation.
With the exception of certain central clearing parties, HSBC includes all third-party counterparties in the CVA and
DVA calculations and does not net these calculations across HSBC Group entities.