RBS 2006 Annual Report Download - page 161
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Please find page 161 of the 2006 RBS annual report below. You can navigate through the pages in the report by either clicking on the pages listed below, or by using the keyword search tool below to find specific information within the annual report.RBS Group • Annual Report and Accounts 2006
160
Notes on the accounts continued
Financial statements
Companies in the Group enter into derivatives as principal
either as a trading activity or to manage balance sheet foreign
exchange, interest rate and credit risk. Derivatives include
swaps, forwards, futures and options. They may be traded on
an organised exchange (exchange-traded) or over-the-counter
(OTC). Holders of exchange traded derivatives are generally
required to provide margin daily in the form of cash or other
collateral.
Swaps include currency swaps, interest rate swaps, credit
default swaps, total return swaps and equity and equity index
swaps. A swap is an agreement to exchange cash flows in the
future in accordance with a pre-arranged formula. In currency
swap transactions, interest payment obligations are exchanged
on assets and liabilities denominated in different currencies;
the exchange of principal may be notional or actual. Interest
rate swap contracts generally involve exchange of fixed and
floating interest payment obligations without the exchange of
the underlying principal amounts.
Forwards include forward foreign exchange contracts and
forward rate agreements. A forward contract is a contract to
buy (or sell) a specified amount of a physical or financial
commodity, at an agreed price, on an agreed future date.
Forward foreign exchange contracts are contracts for the
delayed delivery of currency on a specified future date.
Forward rate agreements are contracts under which two
counterparties agree on the interest to be paid on a notional
deposit of a specified maturity at a specific future date; there
is no exchange of principal.
Futures are exchange-traded forward contracts to buy (or sell)
standardised amounts of underlying physical or financial
commodities. The Group buys and sells currency, interest rate
and equity futures.
Options include exchange-traded options on currencies,
interest rates and equities and equity indices and OTC
currency and equity options, interest rate caps and floors and
swaptions. They are contracts that give the holder the right but
not the obligation to buy (or sell) a specified amount of the
underlying physical or financial commodity at an agreed price
on an agreed date or over an agreed period.
The Group enters into fair value and cash flow hedges and
hedges of net investments in foreign operations. Fair value
hedges principally involve interest rate swaps hedging the
interest rate risk in recognised financial assets and financial
liabilities. Similarly, the majority of the Group’s cash flow hedges
relate to exposure to variability in future interest payments and
receipts on forecast transactions and on recognised financial
assets and financial liabilities and hedged by interest rate swaps
for periods of up to 26 years. The Group hedges its net
investments in foreign operations with currency borrowings.
For cash flow hedge relationships of interest rate risk the hedged
items are actual and forecast variable interest rate cash flows
arising from financial assets and financial liabilities with interest
rates linked to LIBOR or the Bank of England Official Bank
Rate. The financial assets are customer loans and the financial
liabilities are customer deposits and LIBOR linked medium-
term notes and other issued securities.
For cash flow hedging relationships, the initial and ongoing
prospective effectiveness is assessed by comparing movements
in the fair value of the expected highly probable forecast
interest cash flows with movements in the fair value of the
expected changes in cash flows from the hedging interest rate
swap. Prospective effectiveness is measured on a cumulative
basis i.e. over the entire life of the hedge relationship. The
method of calculating hedge ineffectiveness is the hypothetical
derivative method. Retrospective effectiveness is assessed by
comparing the actual movements in the fair value of the cash
flows and actual movements in the fair value of the hedged
cash flows from the interest rate swap over the life to date of
the hedging relationship.
For fair value hedge relationships of interest rate risk the
hedged items are typically large corporate fixed-rate loans,
fixed-rate finance leases, fixed-rate medium-term notes or
preference shares classified as debt. The initial and ongoing
prospective effectiveness of fair value hedge relationships is
assessed on a cumulative basis by comparing movements in
the fair value of the hedged item attributable to the hedged
risk with changes in the fair value of the hedging interest rate
swap. Retrospective effectiveness is assessed by comparing
the actual movements in the fair value of the hedged items
attributable to the hedged risk with actual movements in the
fair value of the hedging derivative over the life to date of the
hedging relationship.
19 Derivatives