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Notes to the consolidated fnancial statements (continued)

for the year ended 30 June 2011

34. Group risk management (continued)

34.4 Banking risk management for fnancial instruments (continued)

34.4.3 Market risk

The Bank is exposed to mainly two sources of market risk, being interest rate and foreign exchange (FX) risks. For the purposes of market risk management, these are further broken down into traded and non-traded market risks. The Bank’s market risk management objectives are described below:

INTEREST RATE RISK FOREIGN EXCHANGE RISK

The Bank trades a range of on-balance sheet and derivative interest rate products. The principal objective of traded interest rate risk management is to generate income through disciplined trading, provide a service to the Bank’s customers and act as a market maker to internal customers. Income is earned from spreads achieved through market making and from effective trading conducted within the traded market risk management framework.

The Bank trades a range of foreign exchange products including derivatives. The principal objective of traded foreign exchange risk management is to generate income through disciplined trading, provide a service to the Bank’s customers and act as a market maker to internal customers. Income is earned from spreads achieved through market making and from effective trading conducted within the traded market risk management framework.

The principal objective of non-traded interest rate risk management is to maximise and stabilise net interest income and the present value of the statement of fnancial position over time providing secure and sustainable net interest income in the long-term. Derivative fnancial instruments are used for the purposes of managing existing or anticipated interest rate risk from non-trading activities.

Non-traded foreign exchange risk arises where investments in non-Australian operations expose current and future earnings to movements in foreign exchange rates. The objective of foreign currency exchange risk management is to minimise the impact on earnings of any such movements. The policy is to fully hedge any such exposure and accordingly minimal exposure to non-traded foreign exchange risk exists. All offshore borrowing facilities arranged as part of the overall funding diversifcation process (refer ‘Concentrations of deposit and borrowing’ in Liquidity Risk) have been economically hedged in respect of their potential foreign exchange risk, through the use of derivative fnancial instruments.

(a) Traded market risk measurement: Value at risk (VaR)

Traded interest rate and foreign exchange risks are managed using a framework that includes value at risk (VaR) limits, sensitivity limits and stop loss limits. VaR measures potential loss using historically observed market volatility and correlation between different markets. It is a statistical estimate of the potential loss that could be incurred if the Bank’s trading positions were maintained for a pre-defned time period. VaR is predominantly calculated using historical simulation. This method involves multiple revaluations of the trading books using two years of historical pricing shifts. The pricing data is rolled daily so as to have the most recent two-year history of prices. The results are ranked and the loss at the 99th percentile confdence interval identifed. The calculation and rate shifts used assume a one-day holding period for all positions. A 99% confdence level implies that for every 100 days, the loss should not exceed the VaR on 99 of those days.

The VaR model, based on a Monte Carlo simulation methodology, takes into account correlations between different positions and the potential for movements to offset one another within the individual portfolios. The major limitation of this methodology is that the historical market data used to forecast parameters of the model might not be an appropriate proxy of those parameters. Market risk from proprietary trading activities is independently calculated and monitored on a daily basis. Actual results are back-tested to check the accuracy of the model and scenario analysis is regularly performed to simulate more extreme market movements. (b) Traded market risk

The VaR for the Bank’s exposure to traded interest rate and foreign exchange risks for the year are as follows:

BANKING

2011 2010

Interest Combined Interest Combined rate risk FX risk risk 1 rate FX risk risk 1 $m $m $m $m $m $m

Traded market risks

VaR at end of the fnancial year 0.60 0.45 0.82 1.48 0.46 1.53 Maximum VaR during the fnancial year 1.47 0.80 1.60 2.26 0.85 2.46 Minimum VaR during the fnancial year 0.41 0.04 0.43 0.58 0.08 0.74 VaR during the fnancial year 0.75 0.33 0.91 1.59 0.32 1.69

Note

1 VaR for combined risk is the total trading interest rate and foreign exchange risks, taking into account correlations between different positions in both the interest rate and foreign exchange trading portfolios.