HSBC 2013 Annual Report Download - page 107

24 Fair values of financial instruments (continued)
Determination of fair value (continued)
A detailed description of the valuation techniques applied to instruments of particular interest follows:
– Private equity
The bank’s private equity positions 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. The
exercise of judgment is required because of uncertainties inherent in estimating fair value for private equity investments.
– Debt securities, treasury and other eligible bills, and equities
The fair value of these instruments is based on quoted market prices from an exchange, dealer, broker, industry group
or pricing service, when available. When unavailable, the fair value is determined by reference to quoted market
prices for similar instruments, adjusted as appropriate for the specific circumstances of the instruments.
In the absence of quoted market prices, fair value is determined using valuation techniques based on the calculation
of the present value of expected future cash flows of the assets. The inputs to these valuation techniques are derived
from observable market data and, where relevant, assumptions in respect of unobservable inputs.
– Derivatives
Over-the-counter (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 modeling 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. Finally, some inputs are
not observable, but can generally be estimated from historical data or other sources. Examples of inputs that are
generally observable include foreign exchange spot and forward rates, benchmark interest rate curves and volatility
surfaces for commonly traded option products. Examples of inputs that may be unobservable include volatility
spreads, 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.
As a result of changing market practices in response to regulatory and accounting changes, as well as general
market developments, the bank revised its methodology for estimating the credit valuation adjustment (‘CVA’) and
debit valuation adjustment (‘DVA’) for derivatives from 1 January 2013. This change is discussed in note 1 (iii)
Basis of presentation.
Derivative products valued using valuation techniques with significant unobservable inputs comprise certain
long-dated foreign exchange options.
– Structured notes
The fair value of structured notes is derived from the fair value of the underlying debt security as described above,
and the fair value of the embedded derivative is determined as described in the paragraph above on derivatives.
Trading liabilities valued using a valuation technique with significant unobservable inputs 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. The notes are classified as Level 3 due to the unobservability of parameters
such as long-dated equity volatilities, correlations between equity prices and interest rates and between interest rates
and foreign exchange rates.
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