Notes to the Financial Statements

for the year ended 31 December 2004

46 Financial Instruments

Banking financial instruments
Notwithstanding the exemption available to insurance groups from the scope of FRS 13, the tables below set out details of derivative financial instruments in respect of the banking activities of the Group.

The banking business uses off-balance sheet financial instruments (derivatives) to meet customers’ requirements for proprietary trading and to hedge interest rate risk, foreign exchange risk and other market risks.

These figures do not demonstrate the exposure of the Group to interest rate, foreign exchange or commodity market risks, since they include only off-balance sheet instruments. The market risk exposure arising from such instruments may be increased or offset by on-balance sheet transactions.

Replacement cost is defined as the cost of replacing transactions that have a positive fair value.

The following analysis summarises the timing mismatch of interest receivable on assets and interest payable on liabilities by reference to the earliest date on which repricing to market value can occur.

The fair value of all of the Group’s financial assets and liabilities is the same as the book value of those assets and liabilities in all instances except for non-trading book debt securities with a book value of £1,691 million (R18,340 million) at 31 December 2004 (2003: £1,411 million (R16,838 million)) and non-trading book equity securities with a book value of £309 million (R3,352 million) at 31 December 2004 (2003: £306 million (R3,646 million)).

All financial assets and liabilities held or issued for trading purposes are carried in the financial statements at fair value. For those financial assets and liabilities in the non-trading book, fair values have been determined by valuation against mid-market prices or by discounting forward cash flows.

46(f) Market risk - historical value-at-risk (VaR) (99%, one day) by risk type
This risk measure estimates the potential loss in pre-tax profit over a given holding period for a specified confidence level. The VaR methodology is a statistically defined, probability-based approach that takes account of market volatilities as well as risk diversification by recognising offsetting positions and correlations between products and markets.

The one day 99% VaR number represents the overnight loss that has less than a 1% chance of occurring under normal market conditions.

While VaR captures the banking business’s exposure under normal market conditions, scenario analysis and, in particular, stress testing are used to add insight to the possible outcomes under abnormal market conditions.

The banking business uses a number of stress scenarios to measure the impact on portfolio values of extreme moves in markets, based on historical experience as well as hypothetical scenarios. The stress test methodology assumes that all market factors move adversely at the same time and that no actions are taken during the stress events to mitigate risk, thereby reflecting the decreased liquidity that frequently accompanies market shocks.

Key to the effectiveness of the scenario analysis programme is the timely review of the continued applicability of the scenarios, and this is built into the risk management process.