HSBC 2012 Annual Report Download - page 441

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Overview
Operating & Financial Review
Corporate Governance
Financial Statements
Shareholder Information
bid/offer spread represents the difference in prices at which a market participant would be willing to buy compared
with the price at which they would be willing to sell. 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.
Valuation techniques incorporate assumptions about factors that other market participants would use in their
valuations, including interest rate yield curves, exchange rates, volatilities, and prepayment and default rates. For
swaps with collateralised counterparties and in significant major currencies, HSBC uses a discounting curve that
reflects the overnight interest rate (‘OIS discounting’).
The majority of valuation techniques employ only observable market data. However, certain financial instruments are
valued on the basis of valuation techniques that feature one or more significant market inputs that are unobservable,
and for them the measurement of fair value is more judgemental. An instrument in its entirety is classified as valued
using significant unobservable inputs if, in the opinion of management, a significant proportion of the instrument’s
inception profit (‘day 1 gain or loss’) or greater than 5% of the instrument’s carrying value is driven by unobservable
inputs. ‘Unobservable’ in this context means that there is little or no current market data available from which to
determine the price at which an arm’s length transaction would be likely to occur. It generally does not mean that
there is no data available at all upon which to base a determination of fair value (consensus pricing data may, for
example, be used).
In certain circumstances, HSBC records its own debt in issue at fair value, based on quoted prices in an active market
for the specific instrument concerned, where available. An example of this is where own debt in issue is hedged with
interest rate derivatives. When quoted market prices are unavailable, the own debt in issue is valued using valuation
techniques, the inputs for which are either based upon quoted prices in an inactive market for the instrument, or are
estimated by comparison with quoted prices in an active market for similar instruments. In both cases, the fair value
includes the effect of applying the credit spread which is appropriate to HSBC’s liabilities. The change in fair value
of issued debt securities attributable to the Group’s own credit spread is computed as follows: for each security at
each reporting date, an externally verifiable price is obtained or a price is derived using credit spreads for similar
securities for the same issuer. Then, using discounted cash flow, each security is valued using a Libor-based discount
curve. The difference in the valuations is attributable to the Group’s own credit spread. This methodology is applied
consistently across all securities.
Structured notes issued and certain other hybrid instrument liabilities are included within trading liabilities and are
measured at fair value. The credit spread applied to these instruments is derived from the spreads at which HSBC
issues structured notes.
Gains and losses arising from changes in the credit spread of liabilities issued by HSBC reverse over the contractual
life of the debt, provided that the debt is not repaid at a premium or a discount.
Fair value adjustments
Fair value adjustments are adopted when HSBC considers that there are additional factors that would be considered
by a market participant that are not incorporated within the valuation model. The magnitude of fair value adjustments
depends upon many entity-specific factors, and therefore fair value adjustments may not be comparable across the
banking industry.
HSBC classifies fair value adjustments as either ‘risk-related’ or ‘model-related’. The majority of these adjustments
relate to GB&M.
Movements in the level of fair value adjustments do not necessarily result in the recognition of profits or losses
within the income statement. For example, as models are enhanced, fair value adjustments may no longer be required.
Similarly, fair value adjustments will decrease when the related positions are unwound, but this may not result in
profit or loss.