Annual Financial Report - 50a of 56

RNS Number : 6444S

HSBC Holdings PLC

18 March 2016

 

12  Trading assets

Accounting policy

Financial assets are classified as held for trading if they have been acquired principally for the purpose of selling in the near term, or form part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of short-term profit-taking. They are recognised on trade date, when HSBC enters into contractual arrangements with counterparties, and are normally derecognised when sold. They are initially measured at fair value, with transaction costs taken to the income statement. Subsequent changes in their fair values and interest are recognised in the income statement in 'Net trading income'.

Trading assets

		2015		2014
		$m		$m
Trading assets:
- not subject to repledge or resale by counterparties		192,204		247,586
- which may be repledged or resold by counterparties		32,633		56,607
At 31 December		224,837		304,193
Treasury and other eligible bills		7,829		16,170
Debt securities		99,038		141,532
Equity securities		66,491		75,249
		-
Trading securities at fair value		173,358		232,951
Loans and advances to banks1		22,303		27,581
Loans and advances to customers1		29,176		43,661
At 31 December		224,837		304,193

1   Loans and advances to banks and customers include settlement accounts, stock borrowing, reverse repos and other amounts.

Trading securities valued at fair value¹

		2015		2014
		$m		$m
US Treasury and US Government agencies2		14,833		25,880
UK Government		10,177		9,280
Hong Kong Government		6,495		6,946
Other government		48,567		78,774
Asset-backed securities3		3,135		3,494
Corporate debt and other securities		23,660		33,328
Equity securities		66,491		75,249
At 31 December		173,358		232,951

1   Included within these figures are debt securities issued by banks and other financial institutions of $16,403m (2014: $22,399m), of which $1,034m (2014: $2,949m) are guaranteed by various governments.

2   Includes securities that are supported by an explicit guarantee issued by the US Government.

3   Excludes asset-backed securities included under US Treasury and US Government agencies.

Trading securities listed on a recognised exchange and unlisted

		Treasury                 and other              eligible bills		Debt                 securities		Equity                securities		Total
		$m		$m		$m		$m
Fair value
Listed1		295		71,184		66,152		137,631
Unlisted2		7,534		27,854		339		35,727
At 31 December 2015		7,829		99,038		66,491		173,358
Fair value
Listed1		1,311		98,028		74,542		173,881
Unlisted2		14,859		43,504		707		59,070
At 31 December 2014		16,170		141,532		75,249		232,951

1   Included within listed investments are $5,722m (2014: $5,956m) of securities listed in Hong Kong.

2   Unlisted treasury and other eligible bills primarily comprise treasury bills not listed on an exchange but for which there is a liquid market.

13  Fair values of financial instruments carried at fair value

Accounting policy

All financial instruments are recognised initially at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value of a financial instrument on initial recognition is generally its transaction price (that is, the fair value of the consideration given or received). However, sometimes the fair value will be based on other observable current market transactions in the same instrument, without modification or repackaging, or on a valuation technique whose variables include only data from observable markets, such as interest rate yield curves, option volatilities and currency rates. When such evidence exists, HSBC recognises a trading gain or loss at inception ('day 1 gain or loss'), being the difference between the transaction price and the fair value. When significant unobservable parameters are used, the entire day 1 gain or loss is deferred and is recognised in the income statement over the life of the transaction until the transaction matures or is closed out, the valuation inputs become observable or HSBC enters into an offsetting transaction. The fair value of financial instruments is generally measured on an individual basis. However, in cases where HSBC manages a group of financial assets and liabilities according to its net market or credit risk exposure, the fair value of the group of financial instruments is measured on a net basis but the underlying financial assets and liabilities are presented separately in the financial statements, unless they satisfy the IFRSs offsetting criteria as described in Note 32.

 

Critical accounting estimates and judgements

Valuation of financial instruments The best evidence of fair value is a quoted price in an actively traded principal market. The fair values of financial instruments that are quoted in active markets are based on bid prices for assets held and offer prices for liabilities issued. When a financial instrument has a quoted price in an active market, the fair value of the total holding of the financial instrument is calculated as the product of the number of units and the quoted price. The judgement as to whether a market is active may include, but is not restricted to, consideration of factors such as the magnitude and frequency of trading activity, the availability of prices and the size of bid/offer spreads. The 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. Valuation techniques may incorporate assumptions about factors that other market participants would use in their valuations, including: ·   the likelihood and expected timing of future cash flows on the instrument. Judgement may be required to assess the counterparty's ability to service the instrument in accordance with its contractual terms. Future cash flows may be sensitive to changes in market rates; ·   selecting an appropriate discount rate for the instrument. Judgement is required to assess what a market participant would regard as the appropriate spread of the rate for an instrument over the appropriate risk-free rate; and ·   judgement to determine what model to use to calculate fair value in areas where the choice of valuation model is particularly subjective, for example, when valuing complex derivative products. A range of valuation techniques is employed, dependent on the instrument type and available market data. Most valuation techniques are based upon discounted cash flow analyses, in which expected future cash flows are calculated and discounted to present value using a discounting curve. Prior to considering credit risk, the expected future cash flows may be known, as would be the case for the fixed leg of an interest rate swap, or may be uncertain and require projection, as would be the case for the floating leg of an interest rate swap. 'Projection' utilises market forward curves, if available. In option models, the probability of different potential future outcomes must be considered. In addition, the value of some products is dependent on more than one market factor, and in these cases it will typically be necessary to consider how movements in one market factor may affect the other market factors. The model inputs necessary to perform such calculations include interest rate yield curves, exchange rates, volatilities, correlations and prepayment and default rates. For interest rate derivatives with collateralised counterparties and in significant currencies, HSBC uses a discounting curve that reflects the overnight interest rate. 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 or greater than 5% of the instrument's valuation 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).

 

Control framework

Fair values are subject to a control framework designed to ensure that they are either determined or validated by a function independent of the risk taker.

For all financial instruments where fair values are determined by reference to externally quoted prices or observable pricing inputs to models, independent price determination or validation is utilised. In inactive markets HSBC will source alternative market information to validate the financial instrument's fair value, with greater weight given to information that is considered to be more relevant and reliable. The factors that are considered in this regard are, inter alia:

·   the extent to which prices may be expected to represent genuine traded or tradeable prices;

·   the degree of similarity between financial instruments;

·   the degree of consistency between different sources;

·   the process followed by the pricing provider to derive the data;

·   the elapsed time between the date to which the market data relates and the balance sheet date; and

·   the manner in which the data was sourced.

For fair values determined using valuation models, the control framework may include, as applicable, development or validation by independent support functions of (i) the logic within valuation models; (ii) the inputs to these models; (iii) any adjustments required outside the valuation models; and (iv) where possible, model outputs. Valuation models are subject to a process of due diligence and calibration before becoming operational and are calibrated against external market data on an ongoing basis.

Changes in fair value are generally subject to a profit and loss analysis process. This process disaggregates changes in fair value into three high level categories; (i) portfolio changes, such as new transactions or maturing transactions, (ii) market movements, such as changes in foreign exchange rates or equity prices, and (iii) other, such as changes in fair value adjustments (see further below).

The majority of financial instruments measured at fair value are in GB&M. GB&M's fair value governance structure is illustrated below as an example:

Financial liabilities measured at fair value

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 hierarchy

Fair values of financial assets and liabilities are determined according to the following hierarchy:

·   Level 1 - valuation technique using quoted market price: financial instruments with quoted prices for identical instruments in active markets that HSBC can access at the measurement date.

·   Level 2 - valuation technique using observable inputs: financial instruments with quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in inactive markets and financial instruments valued using models where all significant inputs are observable.

·   Level 3 - valuation technique with significant unobservable inputs: financial instruments valued using valuation techniques where one or more significant inputs are unobservable.

·  

The following table sets out the financial instruments by fair value hierarchy.

Financial instruments carried at fair value and bases of valuation

				Valuation techniques
		Quoted market price Level 1		Using observable inputs Level 2		With significant unobservable inputs Level 3		Total
		$m		$m		$m		$m
Recurring fair value measurements at 31 December 2015
Assets
Trading assets		133,095		84,886		6,856		224,837
Financial assets designated at fair value		18,947		4,431		474		23,852
Derivatives		1,922		284,292		2,262		288,476
Financial investments: available for sale		262,929		117,197		4,727		384,853
Liabilities
Trading liabilities		41,462		95,867		4,285		141,614
Financial liabilities designated at fair value		5,260		61,145		3		66,408
Derivatives		2,243		277,618		1,210		281,071
Recurring fair value measurements at 31 December 2014
Assets
Trading assets		180,446		117,279		6,468		304,193
Financial assets designated at fair value		23,697		4,614		726		29,037
Derivatives		4,366		337,718		2,924		345,008
Financial investments: available for sale		241,464		131,264		4,988		377,716
Liabilities
Trading liabilities		62,385		122,048		6,139		190,572
Financial liabilities designated at fair value		3,792		72,361		-		76,153
Derivatives		4,649		334,113		1,907		340,669

The decrease in Level 1 and Level 2 trading assets and liabilities during the period reflects a decrease in inventory across a wide range of securities. The decrease in Level 2 derivative assets and liabilities is driven by participation in 'portfolio compression' exercises and market movement.

Transfers between Level 1 and Level 2 fair values

		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
		$m		$m		$m		$m		$m		$m		$m
At 31 December 2015
Transfers from Level 1 to Level 2		-		67		-		56		1,563		857		100
Transfers from Level 2 to Level 1		-		487		-		2		515		2		-
At 31 December 2014
Transfers from Level 1 to Level 2		2,702		18,149		-		-		22,964		-		-
Transfers from Level 2 to Level 1		-		-		-		-		-		-		-

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

		2015		2014
		$m		$m
Type of adjustment
Risk-related		1,402		1,958
- bid-offer		477		539
- uncertainty		95		357
- credit valuation adjustment		853		871
- debit valuation adjustment		(465)		(270)
- funding fair value adjustment		442		460
- other		0		1
Model-related		97		57
- model limitation		92		52
- other		5		5
Inception profit (Day 1 P&L reserves) (Note 16)		97		114
At 31 December		1,596		2,129

Fair value adjustments declined by $533m during the year. The most significant movement was a decline of $262m in respect of the uncertainty category, driven by the reclassification to model limitation of an adjustment relating to derivative discounting assumptions. This adjustment reduced significantly following contract renegotiations with certain counterparties. The debit valuation adjustment increased by $195m as a result of the widening of HSBC's credit spreads.

Risk-related adjustments

Bid-offer

IFRS 13 'Fair value measurement' 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 over-the-counter ('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 ('FFVA') 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 FFVA and DVA 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.

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.

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.

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.

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			Deriva-           tives		Total		Held for       trading	At fair            value1			Deriva-           tives		Total
		$m		$m		$m		$m		$m		$m		$m		$m		$m
Private equity including strategic investments		3,443		55		453		-		3,951		35		-		-		35
Asset-backed securities		1,053		531		-		-		1,584		-		-		-		-
Loans held for securitisation		-		30		-		-		30		-		-		-		-
Structured notes		-		4		-		-		4		4,250		-		-		4,250
Derivatives with monolines		-		-		-		196		196		-		-		-		-
Other derivatives		-		-		-		2,066		2,066		-		-		1,210		1,210
Other portfolios		231		6,236		21		-		6,488		-		3		-		3
At 31 December 2015		4,727		6,856		474		2,262		14,319		4,285		3		1,210		5,498
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

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 ABSs are legacy positions. 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 mortgage-backed securities, 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 include 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
		$m		$m		$m		$m		$m		$m		$m
At 1 January 2015		4,988		6,468		726		2,924		6,139		-		1,907
Total gains/(losses) recognised in profit or loss		(34)		109		30		95		(573)		(1)		(209)
- trading income/(expense) excluding net interest income		-		109		-		95		(573)		-		(209)
- net income from other financial instruments designated at fair value		-		-		30		-		-		(1)		-
- gains less losses from financial investments		(269)		-		-		-		-		-		-
- loan impairment charges and other credit risk provisions		235		-		-		-		-		-		-
Total gains/(losses) recognised in other comprehensive income1		226		(192)		(11)		(126)		(118)		(1)		(64)
- available-for-sale investments: fair value gains		393		-		-		-		-		-		-
- cash flow hedges: fair value gains/(losses)		-		-		-		(4)		-		-		-
- exchange differences		(167)		(192)		(11)		(122)		(118)		(1)		(64)
Purchases		594		1,745		250		-		2		9		-
New issuances		-		-		-		-		1,471		-		-
Sales		(757)		(1,206)		(50)		-		(66)		(4)		-
Settlements		(32)		(146)		(135)		(38)		(1,260)		-		(241)
Transfers out		(1,471)		(206)		(336)		(1,015)		(1,743)		-		(283)
Transfers in		1,213		284		-		422		433		-		100
At 31 December 2015		4,727		6,856		474		2,262		4,285		3		1,210
Unrealised gains/(losses) recognised in profit or loss relating to assets and liabilities held at 31 December 2015		235		(9)		12		89		384		(1)		267
- trading income/(expense) excluding net interest income		-		(9)		-		89		384		-		267
- net income/(expense) from other financial instruments designated at fair value		-		-		12		-		-		(1)		-
- loan impairment charges and other credit risk provisions		235	?	-		-		-		-		-		-

		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
		$m		$m		$m		$m		$m		$m		$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/(expense) excluding net interest income		-		194		-		959		(25)		-		(5)
- net income 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
Unrealised gains/(losses) recognised in profit or loss relating to assets and liabilities held at 31 December 2014		(24)		1		46		946		(122)		-		134
- trading income/(expense) excluding net interest income		-		1		-		946		(122)		-		134
- net income from other financial instruments designated at fair value		-		-		46		-		-		-		-
- loan impairment charges and other credit risk provisions		(24)	?	-		-		-		-		-		-

1   Included in 'Available-for-sale investments: fair value gains/(losses)' and 'Exchange differences' in the consolidated statement of comprehensive income.

In 2015 movement of Level 3 available-for-sale assets are driven by ABS activity, predominantly in the securities investment conduits.  Transfers out of Level 3 available-for-sale assets demonstrates increased confidence in pricing and price coverage, and transfers in reflect limited availability of third-party prices. Increase in Level 3 held for trading assets is driven by an increase in recently-issued syndicated loans. The decline in Level 3 held for trading liabilities reflects a decline in the outstanding balance of Level 3 equity-linked notes, both as a result of market movement and reduced issuance. The decline in Level 3 derivative assets and liabilities reflects market movement.

Effect of changes in significant unobservable assumptions to reasonably possible alternatives

Sensitivity of Level 3 fair values to reasonably possible alternative assumptions

		Reflected in profit or loss				Reflected in other comprehensive income
		Favourable                    changes		Unfavourable                    changes		Favourable                    changes		Unfavourable                    changes
		$m		$m		$m		$m
Derivatives, trading assets and trading liabilities1		335		(215)		-		-
Financial assets and liabilities designated at fair value		24		(24)		-		-
Financial investments: available for sale		35		(30)		230		(243)
At 31 December 2015		394		(269)		230		(243)
Derivatives, trading assets and trading liabilities1		296		(276)		-		-
Financial assets and liabilities designated at fair value		37		(47)		-		-
Financial investments: available for sale		51		(67)		270		(350)
At 31 December 2014		384		(390)		270		(350)

1   Derivatives, trading assets and trading liabilities are presented as one category to reflect the manner in which these financial instruments are risk managed.

The effect of favourable changes is broadly unchanged over the period. The decrease in the effect of unfavourable changes reflects increased price certainty in respect of private equity and certain legacy funding structures, offset by greater syndicated loan uncertainty as a result of the increased Level 3 balance.

Sensitivity of fair values to reasonably possible alternative assumptions by Level 3 instrument type

		Reflected in profit or loss				Reflected in other comprehensive income
		Favourable                    changes		Unfavourable                    changes		Favourable                    changes		Unfavourable                    changes
		$m		$m		$m		$m
Private equity including strategic investments		54		(53)		152		(171)
Asset-backed securities		18		(12)		57		(51)
Loans held for securitisation		1		(1)		-		-
Structured notes		15		(11)		-		-
Derivatives with monolines		11		(11)		-		-
Other derivatives		179		(87)		-		-
Other portfolios		116		(94)		21		(21)
At 31 December 2015		394		(269)		230		(243)
Private equity including strategic investments		77		(110)		172		(255)
Asset-backed securities		49		(22)		60		(55)
Loans held for securitisation		1		(1)		-		-
Structured notes		14		(9)		-		-
Derivatives with monolines		11		(11)		-		-
Other derivatives		129		(155)		-		-
Other portfolios		103		(82)		38		(40)
At 31 December 2014		384		(390)		270		(350)

Favourable and unfavourable changes are determined on the basis of sensitivity analysis. The sensitivity analysis aims to measure a range of fair values consistent with the application of a 95% confidence interval. Methodologies take account of the nature of the valuation technique employed, as well as the availability and reliability of observable proxy and historical data. When the available data is not amenable to statistical analysis, the quantification of uncertainty is judgemental, but remains guided by the 95% confidence interval.

When the fair value of a financial instrument is affected by more than one unobservable assumption, the above table reflects the most favourable or the most unfavourable change from varying the assumptions individually.

Key unobservable inputs to Level 3 financial instruments

The table below lists key unobservable inputs to Level 3 financial instruments, and provides the range of those inputs as at 31 December 2015. The core range of inputs is the estimated range within which 90% of the inputs fall. A further description of the categories of key unobservable inputs is given below.

Quantitative information about significant unobservable inputs in Level 3 valuations

		Fair value										Key unobservable
		Assets				Liabilities			Valuation technique				inputs		Full range of inputs						Core range of inputs
		$m			$m										Lower			Higher			Lower			Higher
Private equity including strategic investments		3,951			35					See notes on page 389		See notes on page 389			n/a			n/a			n/a			n/a
Asset-backed securities		1,584			-
- CLO/CDO1		511			-					Model - Discounted cash flow		Prepayment rate			1%			6%			1%			6%
										Market proxy		Bid quotes			3			147			54			117
Other ABSs		1,073			-
Loans held for securitisation		30			-
Structured notes		4			4,250
- equity-linked notes		-			3,719					Model - Option model		Equity volatility			12%			72%			19%			43%
										Model - Option model		Equity correlation			35%			93%			43%			79%
- fund-linked notes		-			13					Model - Option model		Fund volatility			6%			8%			6%			8%
- FX-linked notes		-			166					Model - Option model		FX volatility			5%			35%			5%			20%
- other		4			352
Derivatives with monolines		196			-					Model - Discounted cash flow		Credit spread			4%			4%			4%			4%
Other derivatives		2,066			1,210
Interest rate derivatives:
- securitisation swaps		250			455					Model - Discounted cash flow		Prepayment rate			0%			90%			14%			71%
- long-dated swaptions		1,237			119					Model - Option model		IR volatility			3%			66%			20%			41%
- other		176			65
FX derivatives:
- FX options		180			186					Model - Option model		FX volatility			0.5%			35%			5%			14%
- other		10			5
Equity derivatives:
- long-dated single stock options		135			191					Model - Option model		Equity volatility			8%			104%			18%			44%
- other		39			170
Credit derivatives:
- other		39			19
Other portfolios		6,488			3
- structured certificates		4,434			-					Model - Discounted cash flow		Credit volatility			2%			4%			2%			4%
- EM corporate debt		210			-
										Market proxy		Bid quotes			70			124			100			123
- other2		1,844			3
At 31 December 2015		14,319			5,498

Quantitative information about significant unobservable inputs in Level 3 valuations (continued)

		Fair value										Key unobservable
		Assets				Liabilities			Valuation technique				inputs		Full range of inputs						Core range of inputs
		$m			$m										Lower			Higher			Lower			Higher
Private equity including strategic investments		3,716			47					See notes on page 389		See notes on page 389			n/a			n/a			n/a			n/a
Asset-backed securities		2,078			-
- CLO/CDO1		1,122			-					Model - Discounted cash flow		Prepayment rate			1%			6%			1%			6%
										Market proxy		Bid quotes			0			100			54			85
Other ABSs		956			-
Loans held for securitisation		39			-
Structured notes		2			6,092
- equity-linked notes		-			4,744					Model - Option model		Equity volatility			0.2%			65%			18%			38%
										Model - Option model		Equity correlation			27%			92%			44%			79%
- fund-linked notes		-			562					Model - Option model		Fund volatility			6%			8%			6%			8%
- FX-linked notes		2			477					Model - Option model		FX volatility			2%			70%			4%			16%
- other		-			309
Derivatives with monolines		239			1					Model - Discounted cash flow		Credit spread			3%			5%			4%			4%
Other derivatives		2,685			1,906
Interest rate derivatives:
- securitisation swaps		449			1,023					Model - Discounted cash flow		Prepayment rate			0%			50%			6%			18%
- long-dated swaptions		1,044			152					Model - Option model		IR volatility			2%			59%			16%			36%
- other		755			151
FX derivatives:
- FX options		89			95					Model - Option model		FX volatility			0.1%			70%			4%			14%
- other		7			7
Equity derivatives:
- long-dated single stock options		192			256					Model - Option model		Equity volatility			9%			65%			16%			40%
- other		34			162
Credit derivatives:
- other		115			60
Other portfolios		6,347			-
- structured certificates		4,420			-					Model - Discounted cash flow		Credit volatility			0.8%			3%			0.8%			3%
- EM corporate debt		372			-					Market proxy		Credit spread			1%			4%			1%			3%
										Market proxy		Bid quotes			58			131			106			130
- other2		1,555			-
At 31 December 2014		15,106			8,046

1   Collateralised loan obligation/collateralised debt obligation.

2   Includes a range of smaller asset holdings.

Private equity including strategic investments

Given the bespoke nature of the analysis in respect of each holding, it is not practical to quote a range of key unobservable inputs.

Prepayment rates

Prepayment rates are a measure of the anticipated future speed at which a loan portfolio will be repaid in advance of the due date. They are an important input into modelled values of ABSs. A modelled price may be used where insufficient observable market prices exist to enable a market price to be determined directly. Prepayment rates are also an important input into the valuation of derivatives linked to securitisations. They vary according to the nature of the loan portfolio and expectations of future market conditions, and may be estimated using a variety of evidence, such as prepayment rates implied from proxy observable security prices, current or historical prepayment rates and macroeconomic modelling.

Market proxy

Market proxy pricing may be used for an instrument for which specific market pricing is not available, but evidence is available in respect of instruments that have some characteristics in common. In some cases it might be possible to identify a specific proxy, but more generally evidence across a wider range of instruments will be used to understand the factors that influence current market pricing and the manner of that influence.

The range of prices used as inputs into a market proxy pricing methodology may therefore be wide. This range is not indicative of the uncertainty associated with the price derived for an individual security.

Volatility

Volatility is a measure of the anticipated future variability of a market price, tending to increase in stressed market conditions and decrease in calmer market conditions. It is an important input in the pricing of options. In general, the higher the volatility, the more expensive the option will be. This reflects both the higher probability of an increased return from the option and the potentially higher costs that HSBC may incur in hedging the risks associated with the option. If option prices become more expensive, this increases the value of HSBC's long option positions (i.e. the positions in which HSBC has purchased options), while HSBC's short option positions (i.e. the positions in which HSBC has sold options) suffer losses.

Volatility varies by underlying reference market price, and by strike and maturity of the option. Volatility also varies over time. As a result, it is difficult to make general statements regarding volatility levels.

Certain volatilities, typically those of a longer-dated nature, are unobservable. The unobservable volatility is then estimated from observable data. The range of unobservable volatilities quoted in the table on page 387 reflects the wide variation in volatility inputs by reference market price. The core range is significantly narrower than the full range because these examples with extreme volatilities occur relatively rarely within the HSBC portfolio. For any single unobservable volatility, the uncertainty in the volatility determination is significantly less than the range quoted above.

Correlation

Correlation is a measure of the inter-relationship between two market prices and is expressed as a number between minus one and one. A positive correlation implies that the two market prices tend to move in the same direction, with a correlation of one implying that they always move in the same direction. A negative correlation implies that the two market prices tend to move in opposite directions, with a correlation of minus one implying that the two market prices always move in opposite directions. Correlation is used to value more complex instruments where the payout is dependent upon more than one market price. There is a wide range of instruments for which correlation is an input, and consequently a wide range of both same-asset correlations (e.g. equity-equity correlation) and cross-asset correlations (e.g. foreign exchange rate-interest rate correlation) is used. In general, the range of same-asset correlations will be narrower than the range of cross-asset correlations.

Correlation may be unobservable. Unobservable correlations may be estimated based upon a range of evidence, including consensus pricing services, HSBC trade prices, proxy correlations and examination of historical price relationships.

The range of unobservable correlations quoted in the table reflects the wide variation in correlation inputs by market price pair. For any single unobservable correlation, the uncertainty in the correlation determination is likely to be less than the range quoted above.

Credit spread

Credit spread is the premium over a benchmark interest rate required by the market to accept lower credit quality. In a discounted cash flow model, the credit spread increases the discount factors applied to future cash flows, thereby reducing the value of an asset. Credit spreads may be implied from market prices. Credit spreads may not be observable in more illiquid markets.

Inter-relationships between key unobservable inputs

Key unobservable inputs to Level 3 financial instruments may not be independent of each other. As described above, market variables may be correlated. This correlation typically reflects the manner in which different markets tend to react to macroeconomic or other events. Furthermore, the effect of changing market variables upon the HSBC portfolio will depend on HSBC's net risk position in respect of each variable.

HSBC Holdings

The following table provides an analysis of the basis for valuing financial assets and financial liabilities measured at fair value in the financial statements:

Basis of valuing HSBC Holdings' financial assets and liabilities measured at fair value

		2015		2014
		$m		$m
Valuation technique using observable inputs: Level 2
Assets at 31 December
Derivatives		2,467		2,771
Available for sale		4,285		4,073
Liabilities at 31 December
Designated at fair value		19,853		18,679
Derivatives		2,278		1,169

14  Fair values of financial instruments not carried at fair value

Fair values of financial instruments not carried at fair value and bases of valuation

				Fair value
						Valuation techniques
		Carrying amount		Quoted market price Level 1		Using observable inputs Level 2		With significant unobservable inputs Level 3		Total
		$m		$m		$m		$m		$m
Assets and liabilities not held for sale at 31 December 2015
Assets
Loans and advances to banks		90,401		-		88,156		2,255		90,411
Loans and advances to customers		924,454		-		12,412		910,057		922,469
Reverse repurchase agreements - non-trading		146,255		-		145,307		959		146,266
Financial investments: debt securities		44,102		1,163		44,076		19		45,258
Liabilities
Deposits by banks		54,371		-		54,295		76		54,371
Customer accounts		1,289,586		-		1,280,368		9,421		1,289,789
Repurchase agreements - non-trading		80,400		-		80,400		-		80,400
Debt securities in issue		88,949		-		89,023		-		89,023
Subordinated liabilities		22,702		-		24,344		649		24,993
Assets and liabilities not held for sale at 31 December 2014
Assets
Loans and advances to banks		112,149		-		109,087		3,046		112,133
Loans and advances to customers		974,660		-		13,598		959,239		972,837
Reverse repurchase agreements - non-trading		161,713		-		160,600		1,123		161,723
Financial investments: debt securities		37,751		1,418		37,671		74		39,163
Liabilities
Deposits by banks		77,426		-		77,300		98		77,398
Customer accounts		1,350,642		-		1,336,865		13,730		1,350,595
Repurchase agreements - non-trading		107,432		-		107,432		-		107,432
Debt securities in issue		95,947		146		94,325		1,932		96,403
Subordinated liabilities		26,664		-		28,806		1,248		30,054

Fair values are determined according to the hierarchy set out in Note 13.

Other financial instruments not carried at fair value are typically short-term in nature and re-price to current market rates frequently. Accordingly, their carrying amount is a reasonable approximation of fair value. This includes cash and balances at central banks, items in the course of collection from and transmission to other banks, Hong Kong Government certificates of indebtedness and Hong Kong currency notes in circulation, all of which are measured at amortised cost.

Carrying amount and fair value of loans and advances to customers by industry sector

		Carrying amount at 31 December
		Not impaired		Impaired		Total
		$m		$m		$m
2015
Loans and advances to customers		907,698		16,756		924,454
- personal		361,716		9,487		371,203
- corporate and commercial		485,933		7,145		493,078
- financial		60,049		124		60,173
2014
Loans and advances to customers		954,710		19,950		974,660
- personal		377,154		11,800		388,954
- corporate and commercial		527,168		8,016		535,184
- financial		50,388		134		50,522

		Fair value at 31 December
		Not impaired		Impaired		Total
		$m		$m		$m
2015
Loans and advances to customers		906,696		15,773		922,469
- personal		359,559		9,024		368,583
- corporate and commercial		487,196		6,592		493,788
- financial		59,941		157		60,098
2014
Loans and advances to customers		954,347		18,490		972,837
- personal		375,615		10,721		386,336
- corporate and commercial		528,361		7,642		536,003
- financial		50,371		127		50,498

Loans and advances to customers are classified as not impaired or impaired in accordance with the criteria described on page 128.

Analysis of loans and advances to customers by geographical segment

		2015				2014
		Carrying amount		Fair value		Carrying amount		Fair value
		$m		$m		$m		$m
Loans and advances to customers
Europe		392,041		392,540		409,733		413,373
Asia		356,375		355,249		362,955		361,412
Middle East and North Africa		29,894		29,614		29,063		28,658
North America		128,851		127,532		129,787		126,232
Latin America		17,293		17,534		43,122		43,162
At 31 December		924,454		922,469		974,660		972,837

Valuation

The fair value measurement is HSBC's estimate of the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It does not reflect the economic benefits and costs that HSBC expects to flow from the instruments' cash flows over their expected future lives. Other reporting entities may use different valuation methodologies and assumptions in determining fair values for which no observable market prices are available.

Fair values of the following assets and liabilities are estimated for the purpose of disclosure as described below:

Loans and advances to banks and customers

The fair value of loans and advances is based on observable market transactions, where available. In the absence of observable market transactions, fair value is estimated using valuation models that incorporate a range of input assumptions. These assumptions may include value estimates from third-party brokers which reflect over-the-counter trading activity, forward looking discounted cash flow models using assumptions which HSBC believes are consistent with those which would be used by market participants in valuing such loans, and trading inputs from other market participants which include observed primary and secondary trades.

Loans are grouped, as far as possible, into homogeneous groups and stratified by loans with similar characteristics to improve the accuracy of estimated valuation outputs. The stratification of a loan book considers all material factors including vintage, origination period, estimates of future interest rates, prepayment speeds, delinquency rates, loan-to-value ratios, the quality of collateral, default probability, and internal credit risk ratings.

The fair value of a loan reflects both loan impairments at the balance sheet date and estimates of market participants' expectations of credit losses over the life of the loans, and the fair value effect of re-pricing between origination and the balance sheet date.

The fair value of loans and advances to customers in North America was lower than the carrying amount, primarily in the US, reflecting the market conditions at the balance sheet date. This was due to the challenging economic conditions during the past number of years, including house price depreciation, rising unemployment, changes in consumer behaviour, changes in discount rates and the lack of financing options available to support the purchase of loans and advances. The relative fair values increased during 2015, largely due to improved conditions in the housing industry driven by increased property values and, to a lesser extent, lower required market yields and increased investor demand for these types of loans and advances.

The fair value of loans and advances to customers in Europe is now broadly in line with carrying value, as new business from both new and existing customers reflects the current low interest rate environment.

Financial investments

The fair values of listed financial investments are determined using bid market prices. The fair values of unlisted financial investments are determined using valuation techniques that take into consideration the prices and future earnings streams of equivalent quoted securities.

Deposits by banks and customer accounts

Fair values are estimated using discounted cash flows, applying current rates offered for deposits of similar remaining maturities. The fair value of a deposit repayable on demand is approximated by its carrying value.

Debt securities in issue and subordinated liabilities

Fair values are determined using quoted market prices at the balance sheet date where available, or by reference to quoted market prices for similar instruments.

Repurchase and reverse repurchase agreements - non-trading

Fair values are estimated by using discounted cash flows, applying current rates. Fair values approximate carrying amounts as their balances are generally short dated.

HSBC Holdings

The methods used by HSBC Holdings to determine fair values of financial instruments for the purpose of measurement and disclosure are described above.

Fair values of HSBC Holdings' financial instruments not carried at fair value on the balance sheet

		2015				2014
		Carrying                     amount		Fair                          value1		Carrying                     amount		Fair                          value1
		$m		$m		$m		$m
Assets at 31 December
Loans and advances to HSBC undertakings		44,350		45,180		43,910		45,091
Liabilities at 31 December
Amounts owed to HSBC undertakings		2,152		2,152		2,892		2,906
Debt securities in issue		960		1,224		1,009		1,357
Subordinated liabilities		15,895		18,297		17,255		20,501

1   Fair values were determined using valuation techniques with observable inputs (Level 2).

 

END

 

 

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