Notes 11-15

13 Derivatives

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.

Group
2007 2006
Notional amounts £bn Assets
£m		 Liabilities
£m		 Notional amounts £bn Assets
£m		 Liabilities
£m
Exchange rate contracts
Spot, forwards and futures 2,134 29,829 29,629 1,158 11,290 11,806
Currency swaps 887 14,785 13,789 255 5,023 4,735
Options purchased 488 13,750 – 361 7,408 –
Options written 519 – 13,892 364 – 6,646
               
Interest rate contracts
Interest rate swaps 24,798 202,478 201,487 12,038 76,671 78,979
Options purchased 4,084 30,681 – 1,763 10,852 –
Options written 3,640 – 31,199 1,589 – 10,489
Futures and forwards 3,164 807 987 1,823 285 328
               
Credit derivatives 2,402 34,123 29,855 346 2,336 2,338
               
Equity and commodity contracts 281 10,957 11,222 82 2,816 2,791
337,410 332,060 116,681 118,112
               
Included above are derivatives held for hedging purposes as follows:
               
Fair value hedging:
Exchange rate contracts 62 344 – –
Interest rate contracts 1,598 1,062 804 384
               
Cash flow hedging:
Exchange rate contracts 155 78 41 –
Interest rate contracts 738 1,014 336 451
               
Net investment hedging:
Exchange rate contracts – 211 – –

Hedge ineffectiveness recognised in other operating income comprised:

2007
£m		 2006
£m		 2005
£m
Fair value hedging:
Gains on the hedged items attributable to the hedged risk 81 219 56
Losses on the hedging instruments (87) (215) (80)
Fair value ineffectiveness (6) 4 (24)
Cash flow hedging ineffectiveness 9 4 12
3 8 (12)
Company
2007 2006
Notional amounts
£bn		 Assets
£m		 Liabilities
£m		 Notional amounts
£bn		 Assets
£m		 Liabilities
£m
Exchange contracts 13 154 178 1 – 42
Interest rate contracts 1 19 1 – – –
173 179 – 42

Included above are fair value hedging derivatives liabilities of £54 million (2006 – nil).

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