HSBC 2004 Annual Report Download - page 122

HSBC HOLDINGS PLC
Financial Review (continued)
120
First, the cost of capital assigned to an
individual IGU and used to discount its future cash
flows can have a significant effect on its valuation.
The cost of capital percentage is generally derived
from an appropriate capital asset pricing model,
which itself depends on a number of financial and
economic variables which are established on the
basis of management’ s judgement.
Second, management judgement is required in
deriving discounted cash flow valuations of IGUs.
These valuations are sensitive to the cash flows in
the initial periods for which detailed forecasts are
available, and to assumptions regarding the long-
term sustainable growth rates of cash flows
thereafter. While the acceptable range within which
underlying assumptions can be applied is governed
by the requirement for resulting forecasts to be
compared with actual performance and verifiable
economic data in future years, the cash flow
forecasts necessarily reflect management’ s view of
future business prospects.
Where management’ s judgement is that the
expected cash flows of an IGU have declined and/or
that its cost of capital has increased, the effect will
be to reduce the estimated fair value of the IGU. If
this results in an estimated fair value that is lower
than the carrying value of the IGU, an impairment of
goodwill will be recorded and HSBC’s profit on
ordinary activities will be lower.
Valuation of securities and derivatives
HSBC’ s accounting policy for these instruments is
described in Note 2 (d) and Note 2 (l) in the ‘Notes
on the Financial Statements’ on pages 246 and 248.
HSBC carries debt and equity securities and
derivatives held for trading purposes at fair or ‘mark-
to-market’ value. The mark-to-market of a financial
instrument is defined as the amount at which the
instrument could be exchanged in a current
transaction between willing parties, other than in a
forced or liquidation sale. For those debt and equity
securities not held for trading purposes, and carried
in the accounts at amortised historical cost,
consideration as to whether any such asset should be
written down to reflect impairment takes into
account the fair value of the relevant security. Non-
trading derivatives (which are primarily interest rate
swaps) are accounted for on an accruals basis.
Changes in the value of securities and derivatives
held for trading purposes are reflected in ‘Dealing
profits’ and hence directly impact HSBC’ s profit on
ordinary activities. Any impairment in the value of
debt and equity securities not held for trading
purposes is reported in ‘Amounts written of fixed
asset investments’ and hence reduces HSBC’ s profit
on ordinary activities.
The majority of the Group’ s financial
instruments held for trading purposes are valued
based on quoted market prices. Where quoted market
prices are not available, the fair value reflects
management’ s assessment of the value of these
financial instruments. This assessment may look to a
valuation of comparable instruments for which an
independent price can be established or use a
discounted cash flow model (particularly for debt
securities and derivatives) or model the valuation of
complex instruments based on a components
approach where independent pricing is available for
the underlying components, including interest rate
yield curves, option volatilities and currency rates.
The main factors which management considers
when applying a cash flow model are:
• the likelihood and expected timing of future
cash flows on the instrument. These cash flows
are usually governed by the terms of the
instrument, although management judgement
may be required in situations where the ability
of the counterparty to service the instrument in
accordance with its contractual terms is in
doubt; and
• an appropriate discount rate for the instrument.
Again, management determines this rate, based
on its assessment of the appropriate spread of
the rate for the instrument over the risk free rate.
When valuing instruments by reference to
comparable instruments management takes into
account the maturity, structure and rating of the
instrument to which the position held is being
compared.
When valuing instruments on a model basis
using the fair value of underlying components,
management additionally considers the need for
adjustments to take account of counterparty
creditworthiness, model uncertainty and the future
costs of servicing the portfolio. These adjustments
are based on defined policies which are applied
consistently across the Group.
For derivatives where market observable data
are not available, the initial increase in fair value
indicated by the valuation model, but based on
unobservable inputs, is not recognised immediately
in the profit and loss account. This amount is held
back and recognised over the life of the transaction
in a systematic manner where appropriate, or
released to the profit and loss account when the
inputs become observable, or, when the transaction
matures or is closed out.