RBS 2007 Annual Report Download - page 158

RBS Group • Annual Report and Accounts 2007
156
Notes on the accounts continued
Financial statements
Companies in the Group transact derivatives as principal either
as a trading activity or to manage balance sheet foreign
exchange, interest rate and credit risk.
The Group enters into fair value hedges, 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 25 years. The Group hedges its net
investments in foreign operations with currency borrowings and
forward foreign exchange contracts.
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, EURIBOR 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 or by comparing the respective changes in the price
value of a basis point. 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 or by comparing the respective changes in the price
value of a basis point. 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.
13 Derivatives