Notes to the accounts
for the year ended 31 December 2007
27. Derivative contracts
(a) Why the Group uses derivatives
The Group holds derivatives for risk management and customer facilitation purposes only. The Group does not hold derivatives for trading or other speculative purposes.
Risk management: the Group actively seeks to limit and manage its exposures to risk where that exposure is not desired by the Group. This may take the form of unwanted exposures to a particular currency, type of interest rate or other price risk. By purchasing or selling derivative contracts, the Group is able to mitigate or eliminate such exposures. The principal risk the Group faces through such use of derivative contracts is one of credit risk only. For details of how the Group manages its exposures to credit risk, see (b) below and note 28.
Customer facilitation: The Group's Private Banking entities are involved in providing portfolio management, banking and investment advisory services, primarily to private clients. In carrying out this business they transact as agent and principal in financial assets and liabilities in order to meet customer facilitation requirements. The Group's policy is to hedge, as appropriate, exchange rate and interest rate risk on its customer facilitation positions using foreign exchange and interest rate contracts. This hedging of equal and opposite risks eliminates any market risk, but does not eliminate the possibility of credit risk. For details of how the Group manages its exposures to credit risk, see (b) below and note 28.
(b) What kind of derivatives the Group uses
Currency forwards represent commitments to purchase foreign and domestic currency, including undelivered spot transactions. Foreign currency and interest rate futures are contractual obligations to receive or pay a net amount based on changes in currency rates or interest rates or to buy or sell foreign currency or a financial instrument on a future date at a specified price, established in an organised financial market. For customer facilitation contracts, the credit risk is negligible, as futures contracts are collateralised by cash or marketable securities, and changes in the futures contract value are settled daily with the exchange. For other contracts, the maximum exposure to credit risk is represented by the fair value of the contracts. Forward rate agreements are individually negotiated interest rate futures that call for a cash settlement at a future date for the difference between a contracted rate of interest and the current market rate, based on a notional principal amount.
| 2007 | 2006 | |||||
|---|---|---|---|---|---|---|
| Notional amount £mn |
Assets £mn |
Liabilities £mn |
Notional amount £mn |
Assets £mn |
Liabilities £mn |
|
| Interest rate contracts | 5,921.1 | 6.6 | (6.4) | 1,475.0 | 3.3 | (3.2) |
| Forward foreign exchange contracts | 6,898.4 | 11.7 | (33.6) | 960.2 | 13.9 | (6.6) |
| Equity contracts | 197.7 | 21.1 | (20.1) | 228.3 | 15.4 | (15.8) |
| Commodity contracts | 37.6 | 3.0 | (3.7) | 47.5 | 2.1 | (2.1) |
| 13,054.8 | 42.4 | (63.8) | 2,711.0 | 34.7 | (27.7) | |
The notional amounts of certain types of financial instruments provide a basis for comparison with instruments recognised on the balance sheet but do not necessarily indicate the amounts of future cash flows involved or the current fair value of the instruments and, therefore, do not indicate the Group's exposure to credit or price risks. The derivative instruments become favourable (assets) or unfavourable (liabilities) as a result of fluctuations in market interest rates, indices or foreign exchange rates relative to their terms. The aggregate contractual or notional amount of derivative financial instruments on hand, the extent to which instruments are favourable or unfavourable, and thus the aggregate fair values of derivative financial assets and liabilities, can fluctuate significantly from time to time.
| 2007 | 2006 | ||||||
|---|---|---|---|---|---|---|---|
| Assets £mn |
Liabilities £mn |
Assets £mn |
Liabilities £mn |
||||
| Net-settled interest rate contracts maturing/repricing1 in: | |||||||
| Less than 1 year | 5.4 | (5.5) | 3.3 | (3.2) | |||
| 4 - 5 years | 1.2 | (0.9) | - | - | |||
| 6.6 | (6.4) | 3.3 | (3.2) | ||||
| Gross-settled forward foreign exchange contracts in Private Banks maturing/repricing1 in: |
|||||||
| Less than 1 year | |||||||
| Gross inflows | 6,826.8 | 6,817.9 | 564.7 | 559.8 | |||
| Gross outflows | (6,818.2) | (6,827.7) | (559.7) | (564.8) | |||
| 8.6 | (9.8) | 5.0 | (5.0) | ||||
| 1 - 2 years: | |||||||
| Gross inflows | 17.6 | 17.6 | - | - | |||
| Gross outflows | (17.6) | (17.6) | - | - | |||
| - | - | - | - | ||||
| 2 - 3 years: | |||||||
| Gross inflows | 55.6 | 53.3 | 1.7 | 1.7 | |||
| Gross outflows | (53.3) | (55.6) | (1.7) | (1.7) | |||
| 2.3 | (2.3) | - | - | ||||
| Gross-settled forward foreign exchange contracts in the rest of the Group maturing/repricing1 in: |
|||||||
| Less than 1 year | |||||||
| Gross inflows | 54.5 | 823.0 | 531.1 | 136.8 | |||
| Gross outflows | (53.3) | (842.6) | (523.0) | (137.6) | |||
| 1.2 | (19.6) | 8.1 | (0.8) | ||||
| Net-settled equity contracts maturing/repricing1 in: | |||||||
| Less than 1 year | 14.0 | (13.0) | 0.5 | (0.9) | |||
| 1 - 2 years | 4.1 | (4.1) | 5.9 | (5.9) | |||
| 2 - 3 years | 2.2 | (2.2) | 8.3 | (8.3) | |||
| 3 - 4 years | 0.8 | (0.8) | - | - | |||
| 4 - 5 years | - | - | 0.7 | (0.7) | |||
| 21.1 | (20.1) | 15.4 | (15.8) | ||||
| Net-settled commodity contracts maturing/repricing1 in: | |||||||
| Less than 1 year | 0.9 | (1.6) | - | - | |||
| 1 - 2 years | 1.1 | (1.1) | 0.8 | (0.8) | |||
| 2 - 3 years | 1.0 | (1.0) | 0.6 | (0.6) | |||
| 3 - 4 years | - | - | 0.7 | (0.7) | |||
| 3.0 | (3.7) | 2.1 | (2.1) | ||||
| 42.8 | (61.9) | 33.9 | (26.9) | ||||
Currency and interest rate swaps are commitments to exchange one set of cash flows for another. Swaps result in an economic exchange of currencies or interest rates (for example, fixed rate for floating rate) or a combination of all these (i.e. cross-currency interest rate swaps). No exchange of principal takes place, except for certain currency swaps. The Group's credit risk represents the potential cost to replace the swap contracts if counterparties fail to perform their obligation. This risk is monitored on an ongoing basis with reference to the current fair value, a proportion of the notional amount of the contracts and the liquidity of the market. To control the level of credit risk taken, the Company assesses counterparties using the same techniques as for its lending activities.
Foreign currency, equity and interest rate options are contractual agreements under which the seller (writer) grants the purchaser (holder) the right, but not the obligation, either to buy (a call option) or sell (a put option) at or by a set date or during a set period, a specific amount of a foreign currency or a financial instrument at a predetermined price. The seller receives a premium from the purchase in consideration for the assumption of foreign exchange, equity or interest rate risk. Options may be either exchange-traded or negotiated between the Group and a customer (OTC). The Group is exposed to credit risk on purchased options only, and only to the extent of their carrying amount, which is their fair value.