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Derivative financial instruments and hedge accounting
 12 Months Ended
Dec. 31, 2019
Text block [abstract]  
Derivative financial instruments and hedge accounting
16. Derivative financial instruments and hedge accounting
The Group’s approach to the management of financial risks is set out in note 19. The Group’s outstanding derivative financial instruments are as follows:
 
 
 
2019
 
 
2018
 
All figures in £ millions
 
Gross notional
amounts
 
 
Assets
 
 
Liabilities
 
 
Gross notional
amounts
 
 
Assets
 
 
Liabilities
 
Interest rate derivatives – in a fair value hedge relationship
 
 
336
 
 
 
13
 
 
 
—  
 
 
 
404
 
 
 
13
 
 
 
—  
 
Interest rate derivatives – not in a hedge relationship
 
 
557
 
 
 
2
 
 
 
(6
) 
 
 
362
 
 
 
3
 
 
 
—  
 
Cross-currency rate derivatives – in a hedge relationship
 
 
502
 
 
 
29
 
 
 
(31
) 
 
 
577
 
 
 
51
 
 
 
(35
) 
FX derivatives – in a hedge relationship
 
 
555
 
 
 
6
 
 
 
(1
) 
 
 
434
 
 
 
—  
 
 
 
(24
) 
FX derivatives – not in a hedge relationship
 
 
386
 
 
 
4
 
 
 
(1
) 
 
 
473
 
 
 
1
 
 
 
—  
 
 
 
 
  
 
 
  
 
 
  
 
 
  
 
 
  
 
 
 
Total
 
 
2,336
 
 
 
54
 
 
 
(39
) 
 
 
2,250
 
 
 
68
 
 
 
(59
) 
 
 
 
  
 
 
  
 
 
  
 
 
  
 
 
  
 
 
 
Analysed as expiring:
 
 
 
 
 
 
In less than one year
 
 
1,167
 
 
 
25
 
 
 
(15
) 
 
 
771
 
 
 
1
 
 
 
(23
) 
Later than one year and not later than five years
 
 
694
 
 
 
13
 
 
 
(6
) 
 
 
795
 
 
 
22
 
 
 
(1
) 
Later than five years
 
 
475
 
 
 
16
 
 
 
(18
) 
 
 
684
 
 
 
45
 
 
 
(35
) 
 
 
 
  
 
 
  
 
 
  
 
 
  
 
 
  
 
 
 
Total
 
 
2,336
 
 
 
54
 
 
 
(39
) 
 
 
2,250
 
 
 
68
 
 
 
(59
) 
 
 
 
  
 
 
  
 
 
  
 
 
  
 
 
  
 
 
 
The Group’s treasury policies only allow derivatives to be traded where the objective is risk mitigation. These are then designated for hedge accounting using the following criteria:
 
 
•
 
If the derivative and the underlying hedged exposure would normally be revalued through the income statement and valuation changes are expected to be perfectly or near perfectly equal and opposite, these will not be classified in a hedge relationship.
 
 
•
 
Where interest rate and cross currency interest rate swaps are used to convert fixed rate debt to floating and we expect to receive inflows equal to the fixed rate debt interest, these are classified as fair value hedges.
 
 
•
 
Where derivatives are used to create a future foreign currency liability to provide protection against currency movements affecting the valuation of an overseas investment, these are designated as a net investment hedge.
 
The Group’s fixed rate USD debt is held as fixed rate instruments at amortised cost.
The majority of the Group’s fixed rate euro debt is converted to a floating rate exposure using interest rate and cross-currency swaps. The Group receives interest under its euro debt related swap contracts to match the interest on the bonds (ranging from a receipt of 1.375% on its euro 2025 notes to 1.875% on its euro 2021 notes) and, in turn, pays either a floating US dollar or sterling variable rates of GBP Libor + 0.81% and US Libor + 1.36%.
GBP and USD Interest rate swaps are subsequently used to fix an element of the interest charge. The
all-in
rates (including the spread above Libor) that the Group pays are between 2.2% and 3.6%. In addition to this the Group has executed additional interest rate swaps to offset the floating rate borrowings paying between 0.83% and 2.1%. At 31 December 2019, the Group had interest rate swap contracts to fix £557m of debt and a further £246m of outstanding fixed rate bonds bringing the total fixed rate debt to £803m. These fixed interest rate derivatives are not in designated hedging relationships. Additionally the Group uses FX derivatives including forwards, collars and cross currency swaps to create synthetic USD debt as a hedge of its USD assets and to achieve certainty of USD currency conversion rates, in line with the Group’s FX hedging policy. Outstanding contracts as at 31 December 2019 were held at an average GBP/USD rate of 1.34. These derivatives are in designated net investment hedging relationships. The weighted average rate achieved for the bonds in a net investment hedge relationship was GBP/USD 1.59 for the USD bonds and EUR/GBP 0.86 for the euro bonds. Outstanding contracts on the cross currency swaps at 31 December 2019 were held at an average EUR/GBP rate of 0.79. These derivatives are in designated fair value hedging relationships.
At the end of 2019, the currency split of the
mark-to-market
values of rate derivatives, including the exchange of principal on cross currency rate derivatives, was US dollar £(167)m, sterling £(166)m and euro £336m (2018: US dollar £(185)m, sterling £(215)m and euro £432m).
The Group’s portfolio of rate derivatives is diversified by maturity, counterparty and type. Natural offsets between transactions within the portfolio and the designation of certain derivatives as hedges significantly reduce the risk of income statement volatility. The sensitivity of the portfolio to changes in market rates is set out in note 19.
Fair value hedges
The Group uses Interest Rate Swaps and Cross Currency Swaps as Fair value hedges of the Groups euro issued debt.
Interest rate exposure arises from movements in the fair value of the Group’s euro debt attributable to movements in euro interest rates. The hedged risk is the change in the euro bonds fair value attributable to interest rate movements. The hedged items are the Group’s euro bonds which are issued at a fixed rate. The hedging instruments are fixed to floating euro interest rate swaps where the Group receives fixed interest payments and pays three month Euribor.
As the critical terms of the interest rate swaps match the bonds, there is an expectation that the value of the hedging instrument and the value of the hedged item will move in the opposite direction as a result of movements in the zero coupon Euribor curve. The hedge ratio is therefore expected to be 100%. Sources of hedge ineffectiveness are a reduction or modification in the hedged item or a material change in the credit risk of swap counterparties.
 
A foreign currency exposure arises from foreign exchange fluctuations on translation of the Group’s euro debt into GBP. The hedged risk is the risk of changes in the GBPEUR spot rate that will result in changes in the value of the euro debt when translated into GBP. The hedged items are a portion of the Group’s euro bonds. The hedging instruments are floating to floating cross currency swaps which creates an exposure to euro strengthening against GBP within the hedge item. The final exchange on the cross currency swap creates an exposure to euro weakening against GBP.
As the critical terms of the cross currency swap match the bonds there is an expectation that the value of the hedging instrument and the value of the hedged item move in the opposite direction as a result of movements in the EURGBP exchange rate. The hedge ratio is 100%. Sources of hedge ineffectiveness are a reduction or modification in the hedged item or a material change in the credit risk of swap counterparties.
The Group held the following instruments to hedge exposures to changes in interest rates and foreign currency risk associated with borrowings:
 
 
 
 
2019
 
All figures in £ millions
 
Carrying amount of
hedging instruments
 
 
Change in fair value of
hedging instrument
used to determine
hedge ineffectiveness
 
 
Nominal amounts of
hedging instruments
 
Derivative financial instruments for interest rate risk
 
 
13
 
 
 
—  
 
 
 
336
 
Derivative financial instruments for currency risk
 
 
25
 
 
 
(21
) 
 
 
336
 
 
 
 
 
2018
 
All figures in £ millions
 
Carrying amount of
hedging instruments
 
 
Change in fair value of
hedging instrument
used to determine
hedge ineffectiveness
 
 
Nominal amounts of
hedging instruments
 
Derivative financial instruments for interest rate risk
 
 
13
 
 
 
(7
) 
 
 
404
 
Derivative financial instruments for currency risk
 
 
51
 
 
 
3
 
 
 
404
 
The amounts at the reporting date relating to items designated as hedge items were as follows:
 
 
 
 
2019
 
All figures in
£ millions
 
Carrying amount
of hedged items
 
 
Accumulated amount
of fair value hedge
adjustments on
the hedged item
included in the
carrying amount
 
 
Change in fair value of
hedged item used to
determine hedge
ineffectiveness
 
 
Hedge
ineffectiveness
 
 
Line item in profit or
loss that includes
hedge ineffectiveness
 
Interest rate risk
 
 
 
 
 
Financial liabilities – borrowings
 
 
(347
) 
 
 
(9
) 
 
 
—  
 
 
 
—  
 
 
 
n/a
 
Currency risk
 
 
 
 
 
Financial liabilities – borrowings
 
 
(347
) 
 
 
n/a
 
 
 
21
 
 
 
—  
 
 
 
n/a
 
 
 
 
 
2018
 
All figures in
£ millions
 
Carrying amount
of hedged items
 
 
Accumulated amount
of fair value hedge
adjustments on
the hedged item
included in the
carrying amount
 
 
Change in fair value of
hedged item used to
determine hedge
ineffectiveness
 
 
Hedge
ineffectiveness
 
 
Line item in profit or
loss that includes
hedge ineffectiveness
 
Interest rate risk
 
 
 
 
 
Financial liabilities – borrowings
 
 
(416
) 
 
 
(9
) 
 
 
7
 
 
 
—
 
 
 
n/a
 
Currency risk
 
 
 
 
 
Financial liabilities – borrowings
 
 
(416
) 
 
 
n/a
 
 
 
(3
) 
 
 
—
 
 
 
n/a
 
Hedge of net investment in a foreign operation
A foreign currency exposure arises from the translation of the Group’s net investments in its subsidiaries which have USD and euro functional currencies. The hedged risk is the risk of changes in the GBPUSD and GBPEUR spot rates that will result in changes in the value of the Group’s net investment in its USD and euro assets when translated into GBP. The hedged items are a portion of the Group’s assets which are denominated in USD and euro. The hedging instruments are debt and derivative financial instruments, including Cross Currency Swaps, FX Forwards and FX Collars which creates an exposure to USD and euro weakening against GBP.
It is expected that the change in value of each of these items will mirror each other as there is a clear and direct economic relationship between the hedge and the hedged item in the hedge relationship.
Hedge ineffectiveness would arise if the value of the hedged items fell below the value of the hedging instruments however this is unlikely as the value of the Group’s assets denominated in USD and euro are significantly greater than the proposed net investment programme.
The amounts related to items designated as hedging instruments were as follows:
 
 
 
  
2019
 
All figures in £ millions
  
Carrying
amount of
hedged
instruments
 
 
Change in value of
hedging
instrument used
to determine
hedge
ineffectiveness
 
  
Nominal
amounts
of hedging
instruments
 
 
Hedging
gains/(losses)
recognised in
OCI
 
  
Hedge
ineffectiveness
recognised in
profit or loss
 
Derivative financial instruments
  
 
(21
) 
 
 
13
 
  
 
(722
) 
 
 
13
 
  
 
—
 
Financial liabilities – borrowings
  
 
(246
) 
 
 
10
 
  
 
(246
) 
 
 
10
 
  
 
—
 
 
 
 
  
2018
 
All figures in £ millions
  
Carrying
amount of
hedged
instruments
 
 
Change in value of
hedging
instrument used
to determine
hedge
ineffectiveness
 
 
Nominal
amounts
of hedging
instruments
 
 
Hedging
gains/(losses)
recognised in
OCI
 
 
Hedge
ineffectiveness
recognised in
profit or loss
 
Derivative financial instruments
  
 
(59
) 
 
 
(22
) 
 
 
(607
) 
 
 
(22
) 
 
 
—  
 
Financial liabilities – borrowings
  
 
(256
) 
 
 
(10
) 
 
 
(256
) 
 
 
(10
) 
 
 
—  
 
 
In addition to the above, £3m of hedging gains were recognised in OCI in relation to derivative financial instruments that matured during the year. Included in the translation reserve is a cost of hedging reserve of £2m relating to the time value of FX collars which is not separately disclosed due to materiality.
Offsetting arrangements with derivative counterparties
All of the Group’s derivative financial instruments are subject to enforceable netting arrangements with individual counterparties, allowing net settlement in the event of default of either party. Derivative financial assets and liabilities subject to offsetting arrangements are as follows:
 
 
 
  
2019
 
 
2018
 
All figures in £ millions
  
Gross
derivative
assets
 
  
Gross
derivative
liabilities
 
 
Net derivative
assets/
liabilities
 
 
Gross
derivative
assets
 
  
Gross
derivative
liabilities
 
 
Net
derivative
assets/
liabilities
 
Counterparties in an asset position
  
 
52
 
  
 
(34
) 
 
 
18
 
 
 
67
 
  
 
(44
) 
 
 
23
 
Counterparties in a liability position
  
 
2
 
  
 
(5
) 
 
 
(3
) 
 
 
1
 
  
 
(15
) 
 
 
(14
) 
  
 
 
   
 
 
  
 
 
  
 
 
   
 
 
  
 
 
 
Total as presented in the balance sheet
  
 
54
 
  
 
(39
) 
 
 
15
 
 
 
68
 
  
 
(59
) 
 
 
9
 
  
 
 
   
 
 
  
 
 
  
 
 
   
 
 
  
 
 
 
All of the Group’s derivative financial instruments are subject to enforceable netting arrangements with individual counterparties, allowing net settlement in the event of default of either party. Offset arrangements in respect of cash balances are described in note 17.
Counterparty exposure from all derivatives is managed, together with that from deposits and bank account balances, within credit limits that reflect published credit ratings and by reference to other market measures (e.g. market prices for credit default swaps) to ensure that there is no significant risk to any one counterparty.
The Group has no material embedded derivatives that are required to be separately accounted for in accordance with IFRS 9 ‘Financial Instruments’.