8 Derivatives and Hedge Accounting

Derivatives

Derivatives held for risk management purposes

Derivatives held for risk management purposes primarily comprise derivatives that share a risk with other financial instruments and give rise to opposite changes in fair value that tend to offset each other (“economic hedges”). The timing of the offset does not match in all cases.

To manage the risks associated with derivative activity, the Group establishes and monitors exposure and risk limits. Exposure to price risk on both derivatives and their underlyings is managed in accordance with risk limits set by risk committees for buying or selling instruments or closing out positions. The risks arise from open positions in interest rates, currencies and equity instruments, all of which are exposed to general and specific market movements.

Derivatives designated and accounted for as hedging instruments

Derivatives designated and accounted for as hedging instruments comprise derivatives associated with fair value hedges, cash flow hedges and net investment hedges in a foreign operation that qualify for hedge accounting.

Hedge accounting

The risk management strategy and objective is to provide protection against an anticipated increase in the general level of interest rates. Generally, payer swaps are used as hedging instruments. In relation to hedge accounting for interest rate risk, the fair value changes of the hedged debt instruments (bonds) and the fair value changes of the payer swaps move in opposite directions and with a similar magnitude in case of changing interest rates (economic relationship).

The parameters of the payer swap are chosen with the purpose of achieving a best possible hedge of future fair value changes of the bonds. A measure of the change in the fair value of a bond due to changing interest rates is its interest rate sensitivity (dollar duration) per one basis point change in interest rates. Defining the parameters of a payer swap such that its dollar duration equals the dollar duration of the bond at hedge inception ensures that the fair values of the two instruments move in opposite directions for (small) changes in interest rates. An economic relationship exists if the dollar durations of the hedged bond and the payer swap do not diverge more than a certain percentage from each other. The differences in the dollar durations are regularly monitored in order to meet the hedge effectiveness requirements at any time. The main source of hedge ineffectiveness originates from the different interest rate convexity at hedge inception. As only on-market swaps are used for hedging purposes, the convexity of the swap will inevitably be different compared to the convexity of the hedged bond.

The risk management strategy and objective is to protect the long-term investment returns on the equity instruments measured at FVOCI (hedged items). For this purpose, equity index options are used as hedging instruments to limit the loss potential and to manage the cost of hedging. The index options may consist of long put, short put and short call options. The long put options provide protection against a decrease of equity prices, while the short put and short call options are used to minimise the cost of hedging. The changes in the intrinsic values of the index options generally move in the opposite direction to the fair value changes of the equity instruments (economic relationship).

The intrinsic value of the index options is designated as the hedging instrument. The initial time value at hedge inception of the index options is amortised to profit or loss over the period during which the hedge adjustment for the option’s intrinsic value could affect other comprehensive income.

Hedge ineffectiveness occurs when the fair value changes of equity instruments – within the boundary of the intrinsic section of the index options – are not entirely offset with the settlement values of the index options at expiration. The tracking error between the equity instruments for any specific market and the corresponding equity index measures the potential for hedge ineffectiveness. A tracking error within a certain range is accepted.

The hedged risk is defined as the fair value changes due to changes in foreign currency rates of equity investments that are classified as FVOCI. Foreign currency forwards are used as hedging instruments in their entirety. An overlay approach is applied when hedging the foreign currency risk of investments that are denominated in a foreign currency. Based on aggregated gross foreign currency exposures, a specific notional amount of foreign currency derivatives is determined in order to manage the net foreign currency exposure within predefined limits. Due to the linear pay-off structure of foreign currency forwards, the fair value changes of foreign currency forwards mirror the fair value changes of equity instruments in terms of the hedged risk. Thus, hedge ineffectiveness does not exist in case the exposure of the equity instruments hedged equals the exposure of the foreign currency forwards. However, as the main purpose of foreign currency hedging is to minimise the volatility in profit and loss in local statutory accounting, the hedge notional of the foreign currency forwards will not in any case equal the foreign currency exposure under IFRS Accounting Standards. These deviations are not a sign of hedge ineffectiveness as long as the risk management objective is adhered to.

Foreign currency risk is managed on an overlay basis. The hedged risk is defined as the fair value changes due to changes in foreign currency rates of net investments in a foreign operation. The hedged items include consolidated real estate funds and fixed-income funds. Foreign currency forward contracts and foreign currency borrowings are used as hedging instruments. The hedge nominal amount of the foreign currency forward or the designated borrowing matches the net asset value of the investment in the foreign operation. Only the change in fair value of the spot element of the forward contract is designated as hedging instrument. Therefore, no hedge ineffectiveness arises.

Derivatives designated as hedging instruments as at 31 December 2024

Derivatives designated as hedging instruments as at 31 December 2023

Foreign currency borrowings designated as hedging instruments

Fair value hedges: designated hedged items

Fair value hedges: timing of notional amounts of the hedging instruments

The risk management strategy and objective of the cash flow hedges is to hedge the interest income of bonds that are expected to be purchased at a future date. Forward starting interest rate receiver swaps and forward bonds are used as hedging instruments. The hedged items are forecasted future bond purchases that are expected to occur with high probability. Future interest income earned on these purchased bonds is hedged with either interest rate receiver swaps or forward bonds. In relation to the swaps, this implies that the accumulated gains or losses on the swaps are closely related to the change in interest income to be earned on the purchased bonds and loans in the future. Amortisation of the accumulated gains or losses of the swaps to profit or loss closely match the change in interest income of the bonds. In the case of forward bonds, the existence of an economic relationship is inherently assumed as a particular bond is the underlying in a forward bond transaction.

When using swaps as hedging instruments, the bonds that are to be purchased and the timing of the purchases must fulfil specific requirements such as a specified amount, maturity date, currency and rating, and must be compatible with the terms of the swaps to a large extent. This ensures that the interest income of a future bond purchase is consistent with the fair value changes of the swap and no significant hedge ineffectiveness is to be expected. In the case of forward bonds, there is no inherent hedge ineffectiveness as a specific bond is the underlying in a forward bond transaction.

Cash flow hedges: designated hedged items – interest rate risk

Cash flow hedges: timing of notional amounts of the hedging instruments – interest rate risk

Hedges of net investments in foreign operations – foreign currency risk