HSBC 2013 Annual Report Download - page 105

103
24 Fair values of financial instruments
Control framework
Fair values are subject to a control framework designed to ensure that they are either determined, or validated, by
a function independent of the risk-taker. To this end, ultimate responsibility for the determination of fair values lies
with the bank’s finance department, (‘Finance’). Finance establishes the accounting policies and procedures governing
valuation, and is responsible for ensuring that they comply with all relevant accounting standards.
For all financial instruments where fair values are determined by reference to externally quoted prices or observable
pricing inputs to models, independent price determination or validation is utilized. In inactive markets, direct observation
of a traded price may not be possible. In these circumstances, the bank will source alternative market information to
validate the financial instrument’s fair value, with greater weight given to information that is considered to be more
relevant and reliable. The factors that are considered in this regard are, inter alia:
– the extent to which prices may be expected to represent genuine traded or tradable prices;
– the degree of similarity between financial instruments;
– the degree of consistency between different sources;
– the process followed by the pricing provider to derive the data;
– the elapsed time between the date to which the market data relates and the reporting date; and
– the manner in which the data was sourced.
Models provide a logical framework for the capture and processing of necessary valuation inputs. For fair values
determined using a valuation model, the control framework may include, as applicable, independent development or
validation of (i) the logic within valuation models; (ii) the inputs to those models; (iii) any adjustments required outside
the valuation models; and, (iv) where possible, model outputs. Valuation models are subject to a process of due diligence
and calibration before becoming operational and are calibrated against external market data on an ongoing basis.
Determination of fair value
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date in the principal, or in its absence, the most advantageous market
to which the Bank has access at that date. The fair value of a liability reflects its non-performance risk.
Fair values are determined according to the following hierarchy:
(a) Level 1 – quoted market price: financial instruments with quoted prices for identical instruments in active markets.
(b) Level 2 – valuation technique using observable inputs: financial instruments with quoted prices for similar
instruments in active markets or quoted prices for identical or similar instruments in inactive markets and financial
instruments valued using models where all significant inputs are observable.
(c) Level 3 – valuation technique with significant unobservable inputs: financial instruments valued using models where
one or more significant inputs are unobservable.
The best evidence of fair value is a quoted price in an actively traded market. In the event that the market for a financial
instrument is not active, a valuation technique is used. The judgement as to whether a market is active may include, but
is not restricted to, the consideration of factors such as the magnitude and frequency of trading activity, the availability
of prices and the size of bid/offer spreads. In inactive markets, obtaining assurance that the transaction price provides
evidence of fair value or determining the adjustments to transaction prices that are necessary to measure the fair value
of the instrument requires additional work during the valuation process.