HSBC 2013 Annual Report Download - page 75

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73
2 Summary of significant accounting policies (continued)
k Derivatives and hedge accounting
Derivatives
Derivatives are recognized initially, and are subsequently re-measured, at fair value. Fair values of exchange traded
derivatives are obtained from quoted market prices. Fair values of over-the-counter derivatives are obtained using
valuation techniques, including discounted cash flow models and option pricing models.
Derivatives are classified as assets when their fair value is positive or as liabilities when their fair value is negative.
The method of recognizing fair value gains or losses depends on whether derivatives are held for trading or are designated
as hedging instruments, and if the latter, the nature of the risks being hedged. All gains and losses from changes in the
fair value of derivatives held for trading are recognized in the income statement. When derivatives are designated as
hedges, the bank classifies them as either: (i) hedges of the change in fair value of recognized assets or liabilities or firm
commitments (‘fair value hedges’); or (ii) hedges of the variability in highly probable future cash flows attributable to
a recognized asset or liability, or a forecast transaction (‘cash flow hedges’). Hedge accounting is applied to derivatives
designated as hedging instruments in a fair value or cash flow hedge provided certain criteria are met.
Hedge accounting
At the inception of a hedging relationship, the bank documents the relationship between the hedging instruments and the
hedged items, its risk management objective and its strategy for undertaking the hedge. The bank also requires a documented
assessment, both at hedge inception and on an ongoing basis, of whether or not the hedging instruments, primarily derivatives,
that are used in hedging transactions are highly effective in offsetting the changes attributable to the hedged risks in the fair
values or cash flows of the hedged items. Interest on designated qualifying hedges is included in ‘Net interest income’.
Fair value hedge
Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded
in the income statement, along with changes in the fair value of the hedged assets, liabilities or group thereof that
are attributable to the hedged risk.
If a hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying
amount of the hedged item is amortized to the income statement based on a recalculated effective interest rate over
the residual period to maturity, unless the hedged item has been derecognized, in which case it is released to the
income statement immediately.
Cash flow hedge
The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges
is recognized in other comprehensive income within the ‘Cash flow hedging reserve’. Any gain or loss in fair value
relating to an ineffective portion is recognized immediately in the income statement. The accumulated gains and
losses recognized in other comprehensive income are reclassified to the income statement in the periods in which
the hedged item will affect profit or loss.
When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any
cumulative gain or loss recognized in other comprehensive income at that time remains in equity until the forecast transaction
is eventually recognized in the income statement. When a forecast transaction is no longer expected to occur, the cumulative
gain or loss that was recognized in other comprehensive income is immediately reclassified to the income statement.
Hedge effectiveness testing
To qualify for hedge accounting, the bank requires that, at the inception of the hedge and throughout its life, each
hedge must be expected to be highly effective (prospective effectiveness), and demonstrate actual effectiveness
(retrospective effectiveness) on an ongoing basis.
The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. The method
the bank adopts for assessing hedge effectiveness will depend on its risk management strategy.
For prospective effectiveness, the hedging instrument must be expected to be highly effective in offsetting changes in
fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For actual
effectiveness to be achieved, the changes in fair value or cash flows must offset each other in the range of 80% to 125%.
Hedge ineffectiveness is recognized in the income statement in ‘Net trading income’.