33. Hedge accounting and other derivative instruments

The Group uses derivative financial instruments for risk management purposes related to the Bank’s operations.

The Group most often uses the following derivative instruments: IRS, CIRS, FX Swap, options, commodity swap, FRA, Forward and Futures.

Derivative financial instruments are stated at fair value from the transaction date.

A derivative is presented under “Derivative hedging instruments” (if the instrument qualifies for hedge accounting) or “Other derivatives” (if the instrument does not qualify for hedge accounting) – as an asset if its fair value is positive or a liability if its fair value is negative.

For other derivatives (not designated for hedge accounting), the Group recognises changes in the fair value of the instruments and the gain or loss on the settlement of these instruments in either the net gain or loss on financial instruments, depending on the type of instrument.

The Group applies hedge accounting to hedge its interest rate risk and foreign exchange risk. The hedging transactions are concluded to mitigate the risk of incurring losses as a result of unfavourable changes in foreign currency exchange rates and interest rates. Cash flows related to the transactions performed, the fair value of assets held and the shares in the net assets of foreign entities are hedged.

Interest rate risk includes in particular:

• the risk related to the repricing (change in interest rates) frequency and dates mismatch of the assets and liabilities, and of off-balance sheet items (repricing date mismatch risk);
• the risk following from the change in the angle of inclination and shape of the yield curve (yield curve risk);
• the risk resulting from an imperfect match between the reference rates used in respect of banking products and the changes in the market rates, or from imperfect transmission systems of changes in market interest rates on those products (base risk);
• risks resulting from options, including embedded options, g. restrictions on interests on loans (option risk).

The Group’s foreign exchange risk arises as a result of transactions performed as part of:

• core business activities;
• trading activities;
• contracts concluded by the Group which generate foreign exchange risk.

Foreign exchange risk arising from the Group’s activities is managed, where required, by specialized units as part of their own operations based on the data received on open currency positions.

The Group has a system of threshold values and limits attributed to particular interest rate and foreign exchange risks, aimed at determining the maximum allowable risk level which ensures that the strategic tolerance limits are not exceeded.

The Group decided to continue to apply the provisions of IAS 39 and did not apply IFRS 9 to hedge accounting.

Changes in the fair value of a derivative financial instrument designated as a cash flow hedge are recognized directly in other comprehensive income in respect of the portion constituting the effective portion of the hedge. The ineffective portion of a hedge is recognized in the income statement in the item „Gains/ (losses) financial transactions” or „Net foreign exchange gains (losses)”.

Amounts transferred directly to other comprehensive income are transferred to the income statement in the same period or periods in which the hedged planned transaction affects the income statement. Interest and foreign exchange gains/losses are presented in the income statement in „Net interest income” and „Net foreign exchange gains (losses)”.

The Group hedges both assets that generate interest income and liabilities that generate interest expense using IRS or CIRS transactions.

The Group consistently applies the method of presenting the total net interest income/(expense) on hedging instruments for all hedging strategies in the line “derivative hedging instruments” under “Net interest income” – the positive total amount for a period is presented in “Interest income” and the negative total amount is presented in “Interest expenses”.

The effectiveness tests comprise the measurement of hedging transactions net of interest accrued and foreign exchange gains (losses) on the nominal value of the hedging transactions (in the case of CIRS transactions).

Hedge effectiveness is verified through the use of prospective and retrospective effectiveness tests. The tests are performed on a monthly basis.

Changes in the fair value of a derivative financial instrument designated for the purposes of hedging interest in the net assets of a foreign operation whose functional currency is a foreign currency are recognized directly in other comprehensive income in respect of the portion constituting the effective portion of the hedge. The ineffective portion of a hedge is recognized in the income statement in the item „Net foreign exchange gains (losses)”.

Gains and losses associated with the hedging instrument relating to the effective portion of the hedge, which were recognized in other comprehensive income, are reclassified to profit or loss as a reclassification adjustment in accordance with paragraphs 48-49 of IAS 21 “The Effects of Changes in Foreign Exchange Rates” upon disposal or partial disposal of the foreign operation.

Hedge effectiveness is verified through the use of prospective and retrospective effectiveness tests.

Changes in the fair value of a derivative hedging instrument designated as fair value hedge are recognized in „Gains/ (losses) financial transactions” net of the interest component. The interest component is presented in the same line item as interest income on the hedged item, i.e. in item „Net interest income”.

The Group hedges both assets that generate interest income and liabilities that generate interest expense using IRS or CIRS transactions. The Group consistently applies the method of presenting the total net interest income/(expense) on hedging instruments for all hedging strategies in the line “derivative hedging instruments” under “Net interest income” – the positive total amount for a period is presented in “Interest income” and the negative total amount is presented in “Interest expenses”.

A change in the fair value adjustment to the hedged item is recognized in „Gains/ (losses) financial transactions”,

The part of the fair value adjustment which is not hedged is recognized:

• for a hedged item which is a financial asset or a financial liability classified as measured at fair value through profit or loss – as income or costs, as appropriate, in gains/(losses) on financial transactions;
• for a hedged item which is a financial asset measured at fair value through other comprehensive income – in other comprehensive income, where the change in the fair value of financial instruments measured at fair value through other comprehensive is presented.

The effectiveness tests comprise the measurement of hedging transactions net of accrued interest.

Hedge effectiveness is verified through the use of prospective and retrospective effectiveness tests. The tests are performed on a monthly basis.

The items securities, loans and advances to customers and amounts due to customers include an adjustment for fair value hedge accounting for securities, loans and advances to customers and amounts due to customers, respectively, representing the hedged item.

The fair value of derivative instruments other than options is determined using valuation models based on discounted cash flows which may be obtained from a given financial instrument. The measurement techniques for financial instruments other than options are based on yield curves constructed on the basis of available market data (deposit rates on the interbank market, quotations of IRS transactions). Options are valued using option pricing models. The variables and assumptions used in a valuation include, where available, data derived from observable markets.

The fair value of derivatives includes the Group’s own credit risk, DVA (debit value adjustment) as well as counterparty credit risk, CVA (credit value adjustment). The process of calculation of CVA and DVA adjustments includes the selection of a method for determining the spread of the counterparty’s or the Group’s credit risk (e.g. a market price method based on the continuous price quotations of debt instruments issued by the counterparty, a method of spread implied from Credit Default Swap contracts), an estimation of the probability of default by the counterparty or the Group and the recovery rate, as well as the calculation of CVA and DVA adjustments.

The Group made simulations to assess the potential impact of changes in the yield curves on the transaction value.