HSBC 2011 Annual Report Download - page 354

HSBC HOLDINGS PLC
Notes on the Financial Statements (continued)
16 – Fair values of financial instruments carried at fair value
352
model and the assumptions relating to prepayment speeds, default rates and loss severity based on collateral type, and
performance, as appropriate. The valuations output is benchmarked for consistency against observable data for
securities of a similar nature.
Loans, including leveraged finance and loans held for securitisation
Loans held at fair value are valued from broker quotes and/or market data consensus providers when available. In the
absence of an observable market, the fair value is determined using valuation techniques. These techniques include
discounted cash flow models, which incorporate assumptions regarding an appropriate credit spread for the loan,
derived from other market instruments issued by the same or comparable entities.
Structured notes
The fair value of structured notes valued using a valuation technique is derived from the fair value of the underlying
debt security, and the fair value of the embedded derivative is determined as described in the paragraph below
on derivatives.
Trading liabilities valued using a valuation technique with significant unobservable inputs principally comprised
equity-linked structured notes, which are issued by HSBC and provide the counterparty with a return that is linked to
the performance of certain equity securities, and other portfolios. The notes are classified as Level 3 due to the
unobservability of parameters such as long-dated equity volatilities and correlations between equity prices, between
equity prices and interest rates and between interest rates and foreign exchange rates.
Derivatives
OTC (i.e. non-exchange traded) derivatives are valued using valuation models. Valuation models calculate the
present value of expected future cash flows, based upon ‘no-arbitrage’ principles. For many vanilla derivative
products, such as interest rate swaps and European options, the modelling approaches used are standard across the
industry. For more complex derivative products, there may be some differences in market practice. Inputs to
valuation models are determined from observable market data wherever possible, including prices available from
exchanges, dealers, brokers or providers of consensus pricing. Certain inputs may not be observable in the market
directly, but can be determined from observable prices via model calibration procedures or estimated from historical
data or other sources. Examples of inputs that may be unobservable include volatility surfaces, in whole or in part, for
less commonly traded option products, and correlations between market factors such as foreign exchange rates,
interest rates and equity prices. The valuation of derivatives with monolines is discussed on page 154.
Derivative products valued using valuation techniques with significant unobservable inputs included certain types of
correlation products, such as foreign exchange basket options, equity basket options, foreign exchange interest rate
hybrid transactions and long-dated option transactions. Examples of the latter are equity options, interest rate and
foreign exchange options and certain credit derivatives. Credit derivatives include certain tranched CDS transactions.