HSBC 2014 Annual Report Download - page 149

HSBC BANK PLC
Notes on the Financial Statements (continued)
147
Private equity including strategic investments
The group’s private equity and strategic investments are generally classified as available for sale and are not traded in
active markets. In the absence of an active market, an investment’s fair value is estimated on the basis of an analysis of
the investee’s financial position and results, risk profile, prospects and other factors, as well as by reference to market
valuations for similar entities quoted in an active market, or the price at which similar companies have changed
ownership. Given the bespoke nature of the analysis in respect of each holding, it is not practical to quote a range of key
unobservable inputs.
Prepayment rates
Prepayment rates are a measure of the anticipated future speed at which a loan portfolio will be repaid in advance of the
due date. Prepayment rates are an important input into modelled values of asset-backed securities. A modelled price may
be used where insufficient observable market prices exist to enable a market price to be determined directly. Prepayment
rates are also an important input into the valuation of derivatives linked to securitisations. For example, so-called
securitisation swaps have a notional value that is linked to the size of the outstanding loan portfolio in a securitisation,
which may fall as prepayments occur. Prepayment rates vary according to the nature of the loan portfolio, and
expectations of future market conditions. For example, prepayment rates will generally be anticipated to increase as
interest rates rise. Prepayment rates may be estimated using a variety of evidence, such as prepayment rates implied
from proxy observable security prices, current or historic prepayment rates, macro-economic modelling.
Market proxy
Market proxy pricing may be used for an instrument for which specific market pricing is not available, but evidence is
available in respect of instruments that have some characteristics in common. In some cases it might be possible to
identify a specific proxy, but more generally evidence across a wider range of instruments will be used to understand the
factors that influence current market pricing and the manner of that influence. For example, in the collateralised loan
obligation market it may be possible to establish that A-rated securities exhibit prices in a range, and to isolate key factors
that influence position within the range. Application of this to a specific A-rated security within HSBC’s portfolio allows
assignment of a price.
The range of prices used as inputs into a market proxy pricing methodology may therefore be wide. This range is not
indicative of the uncertainty associated with the price derived for an individual security.
Volatility
Volatility is a measure of the anticipated future variability of a market price. Volatility tends to increase in stressed market
conditions, and decrease in calmer market conditions. Volatility is an important input in the pricing of options. In general,
the higher the volatility, the more expensive the option will be. This reflects both the higher probability of an increased
return from the option, and the potentially higher costs that HSBC may incur in hedging the risks associated with the
option. If option prices become more expensive, this will increase the value of HSBC’s long option positions (i.e. the
positions in which HSBC has purchased options), while HSBC’s short option positions (i.e. the positions in which HSBC has
sold options) will suffer losses.
Volatility varies by underlying reference market price, and by strike and maturity of the option. Volatility also varies over
time. As a result, it is difficult to make general statements regarding volatility levels. For example, while it is generally the
case that foreign exchange volatilities are lower than equity volatilities, there may be examples in particular currency pairs
or for particular equities where this is not the case.
Certain volatilities, typically those of a longer-dated nature, are unobservable. The unobservable volatility is then
estimated from observable data. For example, longer-dated volatilities may be extrapolated from shorter-dated
volatilities.
The range of unobservable volatilities quoted in the table reflects the wide variation in volatility inputs by reference
market price. For example, FX volatilities for a pegged currency may be very low, whereas for non-managed currencies the
FX volatility may be higher. As a further example, volatilities for deep-in-the-money or deep-out-of-the-money equity
options may be significantly higher than at-the-money options as a result of ‘volatility skew’. For any single unobservable
volatility, the uncertainty in the volatility determination is significantly less than the range quoted above.
Correlation
Correlation is a measure of the inter-relationship between two market prices. Correlation is a number between minus one
and one. A positive correlation implies that the two market prices tend to move in the same direction, with a correlation
of one implying that they always move in the same direction. A negative correlation implies that the two market prices
tend to move in opposite directions, with a correlation of minus one implying that the two market prices always move in
opposite directions.
Correlation is used to value more complex instruments where the payout is dependent upon more than one market price.
For example, an equity basket option has a payout that is dependent upon the performance of a basket of single stocks,
and the correlation between the price movements of those stocks will be an input to the valuation. This is referred to as
equity-equity correlation. There are a wide range of instruments for which correlation is an input, and consequently a
wide range of both same-asset correlations (e.g. equity-equity correlation) and cross-asset correlations (e.g. foreign
exchange rate-interest rate correlation) used. In general, the range of same-asset correlations will be narrower than the
range of cross-asset correlations.