Derivative Financial Instruments

Our business activities involve analysis, evaluation, acceptance and management of some degree of risk or combination of risks. Accordingly, we have comprehensive risk management policies to address potential financial risks, which include credit risk, liquidity risk, market risk, and operational risks. Our risk management policy is designed to identify and analyze these risks, to set appropriate limits and controls, and to monitor the risks and limits continually by means of reliable and up-to-date administrative and information systems. Our risk management policies are primarily carried out in accordance with practice and limits set by the HSBC Group Management Board. The HSBC Finance Corporation Asset Liability Committee (“ALCO”) meets regularly to review risks and approve appropriate risk management strategies within the limits established by the HSBC Group Management Board. Additionally, our Risk Management Committee receives regular reports on our interest rate and liquidity risk positions in relation to the established limits. In accordance with the policies and strategies established by ALCO, in the normal course of business, we enter into various transactions involving derivative financial instruments. These derivative financial instruments primarily are used as economic hedges to manage risk.

Objectives for Holding Derivative Financial Instruments Market risk (which includes interest rate and foreign currency exchange risks) is the possibility that a change in interest rates or foreign exchange rates will cause a financial instrument to decrease in value or become more costly to settle. Prior to our ceasing originations in our Consumer Lending business and ceasing purchase activities in our Mortgage Services business, customer demand for our loan products shifted between fixed rate and floating rate products, based on market conditions and preferences. These shifts in loan products resulted in different funding strategies and produced different interest rate risk exposures. Additionally, the mix of receivables on our balance sheet and the corresponding market risk is changing as we manage the liquidation of all of our receivable portfolios. We maintain an overall risk management strategy that utilizes interest rate and currency derivative financial instruments to mitigate our exposure to fluctuations caused by changes in interest rates and currency exchange rates related to our debt liabilities. We manage our exposure to interest rate risk primarily through the use of interest rate swaps with the main objective of managing the interest rate volatility due to a mismatch in the duration of our assets and liabilities. We manage our exposure to foreign currency exchange risk primarily through the use of cross currency interest rate swaps. We do not use leveraged derivative financial instruments.

Interest rate swaps are contractual agreements between two counterparties for the exchange of periodic interest payments generally based on a notional principal amount and agreed-upon fixed or floating rates. The majority of our interest rate swaps are used to manage our exposure to changes in interest rates by converting floating rate debt to fixed rate or by converting fixed rate debt to floating rate. We have also entered into currency swaps to convert both principal and interest payments on debt issued from one currency to the appropriate functional currency.

We do not manage credit risk or the changes in fair value due to the changes in credit risk by entering into derivative financial instruments such as credit derivatives or credit default swaps.

Control Over Valuation Process and Procedures A control framework has been established which is designed to ensure that fair values are either determined or validated by a function independent of the risk-taker. To that end, the ultimate responsibility for the determination of fair values rests with the HSBC Finance Valuation Committee. The HSBC Finance Valuation Committee establishes policies and procedures to ensure appropriate valuations. Fair values for derivatives are determined by management using valuation techniques, valuation models and inputs that are developed, reviewed, validated and approved by the Quantitative Risk and Valuation Group of an HSBC affiliate. These valuation models utilize discounted cash flows or an option pricing model adjusted for counterparty credit risk and market liquidity. The models used apply appropriate control processes and procedures to ensure that the derived inputs are used to value only those instruments that share similar risk to the relevant benchmark indices and therefore demonstrate a similar response to market factors. In addition, a validation process is followed which includes participation in peer group consensus pricing surveys, to ensure that valuation inputs incorporate market participants' risk expectations and risk premium.

Credit Risk By utilizing derivative financial instruments, we are exposed to counterparty credit risk. Counterparty credit risk is the risk that the counterparty to a transaction fails to perform according to the terms of the contract. We manage the counterparty credit (or repayment) risk in derivative instruments through established credit approvals, risk control limits, collateral, and ongoing monitoring procedures. We utilize an affiliate, HSBC Bank USA, as the primary provider of derivative products. We have never suffered a loss due to counterparty failure.

At December 31, 2012 and 2011, approximately 99.7 percent and 99.0 percent, respectively, of our existing derivative contracts are with HSBC subsidiaries, making them our primary counterparty in derivative transactions. Most swap agreements require that payments be made to, or received from, the counterparty when the fair value of the agreement reaches a certain level. Generally, we provide non-affiliate swap counterparties collateral in the form of cash which is recorded in our balance sheet as derivative financial assets or derivative related liabilities. At December 31, 2012 the fair value of our agreements with non-affiliate counterparties did not require us or the non-affiliates to provide collateral. At December 31, 2011, we provided third party swap counterparties with $10 million of collateral, in the form of cash. When the fair value of our agreements with affiliate counterparties requires the posting of collateral, it is provided in either the form of cash and recorded on the balance sheet, consistent with third party arrangements, or in the form of securities which are not recorded on our balance sheet. The fair value of our agreements with affiliate counterparties required the affiliates to provide collateral to us of $75 million and $584 million at December 31, 2012 and 2011, respectively, all of which was received in cash. These amounts are offset against the fair value amount recognized for derivative instruments that have been offset under the same master netting arrangement and recorded in our balance sheet as a component of derivative financial assets or derivative related liabilities. At December 31, 2012, we had derivative contracts with a notional value of approximately $26.1 billion, including $26.0 billion outstanding with HSBC Bank USA. At December 31, 2011, we had derivative contracts with a notional value of approximately $40.9 billion, including $40.4 billion outstanding with HSBC Bank USA. Derivative financial instruments are generally expressed in terms of notional principal or contract amounts which are much larger than the amounts potentially at risk for nonpayment by counterparties.

To manage our exposure to changes in interest rates, we entered into interest rate swap agreements and currency swaps which have been designated as fair value or cash flow hedges under derivative accounting principles, or are treated as non-qualifying hedges. We currently utilize the long-haul method to assess effectiveness of all derivatives designated as hedges. In the tables that follow below, the fair value disclosed does not include swap collateral that we either receive or deposit with our interest rate swap counterparties. Such swap collateral is recorded on our balance sheet and is netted on the balance sheet against the fair value amount recognized for derivative instruments.

Fair Value Hedges Fair value hedges include interest rate swaps to convert our fixed rate debt to variable rate debt and currency swaps to convert debt issued from one currency into U.S. dollar variable rate debt. All of our fair value hedges are associated with debt. We recorded fair value adjustments to the carrying value of our debt for fair value hedges which increased the carrying amount of our debt by $7 million and $36 million at December 31, 2012 and 2011, respectively. The following table provides information related to the location of derivative fair values in the consolidated balance sheet for our fair value hedges.



	Asset Derivatives Fair Value as of December 31,					Liability Derivatives Fair Value as of December 31,
	Balance Sheet Location	2012		2011		Balance Sheet Location	2012		2011
		(in millions)					(in millions)
Interest rate swaps	Derivative financial assets⁽¹⁾	$	7	$	11	Derivative related liabilities	$	—	$	7
Currency swaps	Derivative financial assets⁽¹⁾	—		53		Derivative related liabilities	—		—
Total fair value hedges		$	7	$	64		$	—	$	7


⁽¹⁾	At December 31, 2012 and December 31, 2011, derivative financial assets are reported on our consolidated balance sheet within other assets.

The following table presents fair value hedging information, including the gain (loss) recorded on the derivative and where that gain (loss) is recorded in the consolidated statement of income (loss) as well as the offsetting gain (loss) on the hedged item that is recognized in current earnings, the net of which represents hedge ineffectiveness.



		Location of Gain (Loss) Recognized	Amount of Gain (Loss) Recognized in Income on the Derivative									Amount of Gain (Loss) Recognized in Income on Hedged Item
	Hedged Item	in Income on Hedged Item and Derivative	2012			2011			2010			2012			2011			2010
			(in millions)
Interest rate swaps	Fixed rate borrowings	Derivative related income	$	(3	)	$	34		$	17		$	(2	)	$	(40	)	$	7
Currency swaps	Fixed rate borrowings	Derivative related income	(17		)	(29		)	(13		)	19			44			12
Total			$	(20	)	$	5		$	4		$	17		$	4		$	19

Cash Flow Hedges Cash flow hedges include interest rate swaps to convert our variable rate debt to fixed rate debt by fixing future interest rate resets of floating rate debt as well as currency swaps to convert debt issued from one currency into U.S. dollar fixed rate debt. Gains and losses on derivative instruments designated as cash flow hedges are reported in other comprehensive income (loss) (“OCI”) net of tax and totaled a loss of $329 million and $448 million at December 31, 2012 and 2011, respectively. We expect $189 million ($122 million after-tax) of currently unrealized net losses will be reclassified to earnings within one year. However, these reclassified unrealized losses will be offset by decreased interest expense associated with the variable cash flows of the hedged items and will result in no significant net economic impact to our earnings. The following table provides information related to the location of derivative fair values in the consolidated balance sheet for our cash flow hedges.



	Asset Derivatives Fair Value as of December 31,							Liability Derivatives Fair Value as of December 31,
	Balance Sheet Location	2012			2011			Balance Sheet Location	2012		2011
		(in millions)							(in millions)
Interest rate swaps	Derivative financial assets⁽¹⁾	$	(450	)	$	(554	)	Derivative related liabilities	$	—	$	—
Currency swaps	Derivative financial assets⁽¹⁾	444			441			Derivative related liabilities	—		—
Total cash flow hedges		$	(6	)	$	(113	)		$	—	$	—


⁽¹⁾	At December 31, 2012 and December 31, 2011, derivative financial assets are reported on our consolidated balance sheet within other assets.

The following table provides the gain or loss recorded on our cash flow hedging relationships.



	Gain (Loss) Recognized in OCI on Derivative (Effective Portion)								Location of Gain (Loss) Reclassified from AOCI into	Gain (Loss) Reclassed From AOCI into Income (Effective Portion)									Location of Gain (Loss) Recognized in Income	Gain (Loss) Recognized In Income on Derivative (Ineffective Portion)
	2012		2011			2010			Income (Effective Portion)	2012			2011			2010			on the Derivative(Ineffective Portion)	2012		2011		2010
	(in millions)
Interest rate swaps	$	95	$	(116	)	$	(65	)	Interest expense	$	(7	)	$	(34	)	$	(62	)	Derivative related income	$	1	$	4	$	(1	)
Currency swaps	89		189			70			Interest expense	(20		)	(25		)	(34		)	Derivative related income	22		22		(7		)
Total	$	184	$	73		$	5			$	(27	)	$	(59	)	$	(96	)		$	23	$	26	$	(8	)

Non-Qualifying Hedging Activities We may enter into interest rate and currency swaps which are not designated as hedges under derivative accounting principles. These financial instruments are economic hedges but do not qualify for hedge accounting and are primarily used to minimize our exposure to changes in interest rates and currency exchange rates through more closely matching both the structure and projected duration of our liabilities to the structure and duration of our assets. The following table provides information related to the location and derivative fair values in the consolidated balance sheet for our non-qualifying hedges:



	Asset Derivatives Fair Value as of December 31,							Liability Derivatives Fair Value as of December 31,
	Balance Sheet Location	2012			2011			Balance Sheet Location	2012		2011
		(in millions)							(in millions)
Interest rate swaps	Derivative financial assets⁽¹⁾	$	(1,084	)	$	(926	)	Derivative related liabilities	$	4	$	5
Currency swaps and foreign exchange forward contracts	Derivative financial assets⁽¹⁾	(7		)	38			Derivative related liabilities	—		4
Total		$	(1,091	)	$	(888	)		$	4	$	9


⁽¹⁾	At December 31, 2012 and December 31, 2011, derivative financial assets are reported on our consolidated balance sheet within other assets.

The following table provides detail of the realized and unrealized gain or loss recorded on our non-qualifying hedges:



	Location of Gain (Loss)	Amount of Gain (Loss) Recognized in Derivative Related Income (Expense)
	Recognized in Income on Derivative	2012			2011			2010
		(in millions)
Interest rate contracts	Derivative related income	$	(221	)	$	(1,185	)	$	(394	)
Currency contracts	Derivative related income	(6		)	4			—
Total		$	(227	)	$	(1,181	)	$	(394	)

We have elected the fair value option for certain issuances of our fixed rate debt and have entered into interest rate and currency swaps related to debt carried at fair value. The interest rate and currency swaps associated with this debt are non-qualifying hedges but are considered economic hedges and realized gains and losses are reported as “Gain (loss) on debt designated at fair value and related derivatives” within other revenues. The derivatives related to fair value option debt are included in the tables below. See Note 11, “Fair Value Option,” for further discussion.



	Asset Derivatives Fair Value as of December 31,					Liability Derivatives Fair Value as of December 31,
	Balance Sheet Location	2012		2011		Balance Sheet Location	2012		2011
		(in millions)					(in millions)
Interest rate swaps	Derivative financial assets⁽¹⁾	$	469	$	693	Derivative related liabilities	$	—	$	—
Currency swaps	Derivative financial assets⁽¹⁾	678		808		Derivative related liabilities	—		—
Total		$	1,147	$	1,501		$	—	$	—


⁽¹⁾	At December 31, 2012 and December 31, 2011, derivative financial assets are reported on our consolidated balance sheet within other assets.

The following table provides the gain or loss recorded on the derivatives related to fair value option debt primarily due to changes in interest rates:



	Location of Gain (Loss) Recognized in Income on Derivative	Amount of Gain (Loss) Recognized in Derivative Related Income (Expense)
	Location of Gain (Loss) Recognized in Income on Derivative	2012		2011		2010
		(in millions)
Interest rate contracts	Gain (loss) on debt designated at fair value and related derivatives	$	70	$	263	$	719
Currency contracts	Gain (loss) on debt designated at fair value and related derivatives	73		260		182
Total		$	143	$	523	$	901

Notional Value of Derivative Contracts The following table summarizes the notional values of derivative contracts:



At December 31,	2012		2011
	(in millions)
Derivatives designated as hedging instruments:
Interest rate swaps	$	4,949	$	8,140
Currency swaps	6,063		8,195
	11,012		16,335
Non-qualifying hedges:
Derivatives not designated as hedging instruments:
Interest rate swaps	6,219		10,523
Foreign exchange:
Swaps	122		715
Forwards	—		205
	6,341		11,443
Derivatives associated with debt carried at fair value:
Interest rate swaps	5,573		9,700
Currency swaps	3,134		3,376
	8,707		13,076
Total	$	26,060	$	40,854

The decrease in the notional value of our derivative contracts at December 31, 2012 as compared to December 31, 2011 primarily reflects the maturity of derivative contracts as well as the termination of $4.2 billion of non-qualifying hedges.