Annual Financial Report - 48 of 54

Fair value adjustments

Fair value adjustments are adopted when HSBC considers that there are additional factors that would be considered by a market participant which are not incorporated within the valuation model. 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.

Global Banking and Markets fair value adjustments

		2014		2013
		US$m		US$m
Type of adjustment
Risk-related		1,958		1,565
-  bid-offer		539		561
-  uncertainty		357		343
-  credit valuation adjustment		871		1,274
-  debit valuation adjustment		(270)		(616)
-  funding fair value adjustment		460		-
-  other		1		3
Model-related		57		202
-  model limitation		52		199
-  other		5		3
Inception profit (Day 1 P&L reserves) (Note 16)		114		167
At 31 December		2,129		1,934

The largest change in recurring fair value adjustments was a decline of US$403m in respect of the credit valuation adjustment, as a result of both reduced derivative counterparty exposures and general narrowing of credit default swap ('CDS') spreads. Narrowing HSBC credit default swap spreads similarly contributed to a reduction in the debit valuation adjustment ('DVA') of US$346m.

Funding fair value adjustment ('FFVA') reflects the potential future cost or benefit of funding the uncollateralised derivative portfolio at rates other than overnight ('OIS') rates. The impact of FFVA adoption in 2014 was a US$263m reduction in net trading income, reflecting the incorporation of a funding spread over Libor. FFVA is measured from an OIS base, and the total FFVA balance of US$460m also reflects the difference between OIS and Libor which had been previously reflected in the fair value of the uncollateralised derivative portfolio.

Risk-related adjustments

Bid-offer

IFRS 13 requires use of the price within the bid-offer spread that is most representative of fair value. Valuation models will typically generate mid-market values. The bid-offer adjustment reflects the extent to which bid-offer costs would be incurred if substantially all residual net portfolio market risks were closed using available hedging instruments or by disposing of or unwinding the position.

Uncertainty

Certain model inputs may be less readily determinable from market data, and/or the choice of model itself may be more subjective. In these circumstances, there exists a range of possible values that the financial instrument or market parameter may assume and an adjustment may be necessary to reflect the likelihood that in estimating the fair value of the financial instrument, market participants would adopt more conservative values for uncertain parameters and/or model assumptions than those used in the valuation model.

Credit valuation adjustment

The CVA is an adjustment to the valuation of OTC derivative contracts to reflect within fair value the possibility that the counterparty may default and that HSBC may not receive the full market value of the transactions (see below).

Debit valuation adjustment

The DVA is an adjustment to the valuation of OTC derivative contracts to reflect within fair value the possibility that HSBC may default, and that HSBC may not pay full market value of the transactions (see below).

 

Funding fair value adjustment

The funding fair value adjustment is calculated by applying future market funding spreads to the expected future funding exposure of any uncollateralised component of the OTC derivative portfolio. This includes the uncollateralised component of collateralised derivatives in addition to derivatives that are fully uncollateralised.  The expected future funding exposure is calculated by a simulation methodology, where available. The expected future funding exposure is adjusted for events that may terminate the exposure such as the default of HSBC or the counterparty. The funding fair value adjustment and debit valuation adjustment are calculated independently.

Model-related adjustments

Model limitation

Models used for portfolio valuation purposes may be based upon a simplifying set of assumptions that do not capture all material market characteristics. Additionally, markets evolve, and models that were adequate in the past may require development to capture all material market characteristics in current market conditions. In these circumstances, model limitation adjustments are adopted. As model development progresses, model limitations are addressed within the valuation models and a model limitation adjustment is no longer needed.

Inception profit (Day 1 P&L reserves)

Inception profit adjustments are adopted when the fair value estimated by a valuation model is based on one or more significant unobservable inputs. The accounting for inception profit adjustments is discussed on page 378. An analysis of the movement in the deferred Day 1 P&L reserve is provided on page 395.

Credit valuation adjustment/debit valuation adjustment methodology

HSBC calculates a separate CVA and DVA for each HSBC legal entity, and within each entity for each counterparty to which the entity has exposure. HSBC calculates the CVA by applying the probability of default ('PD') of the counterparty, conditional on the non-default of HSBC, to HSBC's expected positive exposure to the counterparty and multiplying the result by the loss expected in the event of default. Conversely, HSBC calculates the DVA by applying the PD of HSBC, conditional on the non-default of the counterparty, to the expected positive exposure of the counterparty to HSBC and multiplying the result by the loss expected in the event of default. Both calculations are performed over the life of the potential exposure.

For most products HSBC uses a simulation methodology to calculate the expected positive exposure to a counterparty. This incorporates a range of potential exposures across the portfolio of transactions with the counterparty over the life of the portfolio. The simulation methodology includes credit mitigants such as counterparty netting agreements and collateral agreements with the counterparty. A standard loss given default ('LGD') assumption of 60% is generally adopted for developed market exposures, and 75% for emerging market exposures. Alternative LGD assumptions may be adopted when both the nature of the exposure and the available data support this.

For certain types of exotic derivatives where the products are not currently supported by the simulation, or for derivative exposures in smaller trading locations where the simulation tool is not yet available, HSBC adopts alternative methodologies. These may involve mapping to the results for similar products from the simulation tool or, where the mapping approach is not appropriate, using a simplified methodology which generally follows the same principles as the simulation methodology. The calculation is applied at a trade level, with more limited recognition of credit mitigants such as netting or collateral agreements than is used in the simulation methodology.

The methodologies do not, in general, account for 'wrong-way risk'. Wrong-way risk arises when the underlying value of the derivative prior to any CVA is positively correlated to the probability of default by the counterparty. When there is significant wrong-way risk, a trade-specific approach is applied to reflect the wrong-way risk within the valuation.

With the exception of certain central clearing parties, we include all third-party counterparties in the CVA and DVA calculations and do not net these adjustments across Group entities. We review and refine the CVA and DVA methodologies on an ongoing basis.

Valuation of uncollateralised derivatives

Historically, HSBC has valued uncollateralised derivatives by discounting expected future cash flows at a benchmark interest rate, typically Libor or its equivalent. In line with evolving industry practice, HSBC changed this approach in the second half of 2014. HSBC now views the OIS curve as the base discounting curve for all derivatives, both collateralised and uncollateralised, and has adopted an FFVA to reflect the funding of uncollateralised derivative exposure at rates other than OIS. The impact of adopting the funding fair value adjustment was a reduction in trading revenues of US$263m. This is an area in which a full industry consensus has not yet emerged. HSBC will continue to monitor industry evolution and refine the calculation methodology as necessary.

 

Fair value valuation bases

Financial instruments measured at fair value using a valuation technique with significant unobservable inputs - Level 3

		Assets										Liabilities
		Available      for sale		Held for       trading	At fair            value1			Deriv-        atives		Total		Held for       trading	At fair            value1			Deriv-        atives		Total
		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m
Private equity including strategic investments		3,120		164		432		-		3,716		47		-		-		47
Asset-backed securities		1,462		616		-		-		2,078		-		-		-		-
Loans held for securitisation		-		39		-		-		39		-		-		-		-
Structured notes		-		2		-		-		2		6,092		-		-		6,092
Derivatives with monolines		-		-		-		239		239		-		-		1		1
Other derivatives		-		-		-		2,685		2,685		-		-		1,906		1,906
Other portfolios		406		5,647		294		-		6,347		-		-		-		-
				5,		726
At 31 December 2014		4,988		6,468		726		2,924		15,106		6,139		-		1,907		8,046
Private equity including strategic investments		3,729		103		420		-		4,252		-		-		-		-
Asset-backed securities		1,677		643		-		-		2,320		-		-		-		-
Loans held for securitisation		-		83		-		-		83		-		-		-		-
Structured notes		-		14		-		-		14		7,514		-		-		7,514
Derivatives with monolines		-		-		-		320		320		-		-		-		-
Other derivatives		-		-		-		2,182		2,182		-		-		2,335		2,335
Other portfolios		1,839		4,504		188		-		6,531		-		-		-		-
At 31 December 2013		7,245		5,347		608		2,502		15,702		7,514		-		2,335		9,849

1   Designated at fair value through profit or loss.

Level 3 instruments are present in both ongoing and legacy businesses. Loans held for securitisation, derivatives with monolines, certain 'other derivatives' and predominantly all Level 3 asset-backed securities are legacy. HSBC has the capability to hold these positions.

Private equity including strategic investments

HSBC'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.

Asset-backed securities

While quoted market prices are generally used to determine the fair value of these securities, valuation models are used to substantiate the reliability of the limited market data available and to identify whether any adjustments to quoted market prices are required. For ABSs including residential MBSs, the valuation uses an industry standard 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 alternative 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 with significant unobservable inputs 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.

Level 3 structured notes principally comprise equity-linked 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.

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.

Reconciliation of fair value measurements in Level 3 of the fair value hierarchy

The following table provides a reconciliation of the movement between opening and closing balances of Level 3 financial instruments, measured at fair value using a valuation technique with significant unobservable inputs:

Movement in Level 3 financial instruments

		Assets								Liabilities
		Available            for sale		Held for            trading	Designated     at fair value             through    profit or loss			Derivatives		Held for            trading	Designated     at fair value             through    profit or loss			Derivatives
		US$m		US$m		US$m		US$m		US$m		US$m		US$m
At 1 January 2014		7,245		5,347		608		2,502		7,514		-		2,335
Total gains/(losses) recognised in profit or loss		174		194		56		959		(25)		-		(5)
- ... trading income excluding net interest income		-		194		-		959		(25)		-		(5)
- ....... net income/(expense) from other financial instruments designated at fair value		-		-		56		-		-		-		-
- ........... gains less losses from financial investments		198
- ............. loan impairment charges and other credit risk provisions		(24)
Total gains/(losses) recognised in other comprehensive income1		126		(178)		(16)		(126)		(123)		-		54
- .......... available-for-sale investments: fair value gains/(losses)		208		-		-		-		-		-		-
- .............. cash flow hedges: fair value gains/(losses)		-		-		-		(9)		-		-		34
- ....................... exchange differences		(82)		(178)		(16)		(117)		(123)		-		20
Purchases		1,505		705		273		-		(31)		-		-
New issuances		-		-		-		-		2,067		-		-
Sales		(1,237)		(481)		(149)		-		-		-		-
Settlements		(1,255)		(49)		(78)		27		(1,655)		-		(69)
Transfers out		(3,027)		(112)		-		(544)		(1,918)		-		(527)
Transfers in		1,457		1,042		32		106		310		-		119
At 31 December 2014		4,988		6,468		726		2,924		6,139		-		1,907