Banco Santander (Mexico) S.A., Institucion de Banca Multiple, Grupo Financiero Santander Mexico (ifrs-full:DescriptionOfAccountingPolicyForFairValueMeasurementExplanatory)

d) Measurement of financial assets and liabilities and recognition of fair value changes

In general, financial assets and liabilities are initially recognized at fair value, which, in the absence of evidence to the contrary, is deemed to be the transaction price. The amount initially recognized for financial instruments not measured at FVTPL is adjusted for transaction costs. Financial assets and liabilities are subsequently measured at each period-end as follows:

i. Measurement of financial assets

Financial assets are measured at fair value without deducting any transaction costs that may be incurred on their disposal. Transaction costs are considered for loans and receivables, held-to-maturity investments, equity instruments whose fair value cannot be determined in a sufficiently objective manner and derivative assets that have equity instruments as their underlying and are settled by delivery of those instruments. All financial assets are accounted for at the trade date.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions. The most objective and common reference for the fair value of a financial instrument is the price that would be paid for it on an active, transparent and deep market (quoted price or market price).

At 31 December 2017, there were no significant investments in quoted financial instruments that had ceased to be recognized at their quoted price because their market could not be deemed to be active.

Fair value under IFRS is an exit price regardless of whether that price is directly observable or estimated using another valuation technique.

If there is no market price for a given financial instrument, its fair value is estimated on the basis of the price established in recent transactions involving similar instruments and, in the absence thereof, of valuation techniques commonly used by the international financial community, taking into account the specific features of the instrument to be measured and, particularly, the various types of risk associated with it.

All derivatives are recognized in the consolidated balance sheet at fair value from the trade date. If the fair value is positive, they are recognized as an asset and if the fair value is negative, they are recognized as a liability. In the absence of evidence to the contrary, the fair value on the trade date is deemed to be the transaction price. The changes in the fair value of derivatives from the trade date are recognized in Gains/(losses) on financial assets and liabilities (net) in the consolidated income statement. Specifically, the fair value of derivatives traded in organized markets included in the portfolios of financial assets or liabilities held for trading is deemed to be their daily quoted price. If for exceptional reasons the quoted price cannot be determined on a given date, these financial derivatives are measured using methods similar to those used to measure over-the-counter (hereinafter, OTC) derivatives.

The fair value of OTC derivatives is determined using the most appropriate valuation techniques commonly used by the financial markets based on the characteristics of each financial instrument such as present value, option pricing models and other methods.

Loans and receivables and Held-to-maturity investments are measured at amortized cost using the effective interest method. Amortized cost is the acquisition cost of a financial asset or liability plus or minus, as appropriate, the principal repayments and the cumulative amortization (taken to the consolidated income statement) of the difference between the initial cost and the maturity amount. In the case of financial assets, amortized cost also includes any reduction for impairment or uncollectibility. In the case of Loans and receivables hedged in fair value hedges, the changes in the fair value of these assets related to the risk or risks being hedged are recognized.

The effective interest rate is the discount rate that exactly matches the carrying amount of a financial instrument to all its estimated cash flows of all kinds over its remaining life. For fixed rate financial instruments, the effective interest rate coincides with the contractual interest rate established on the acquisition date and, where applicable, the fees and transaction costs that, because of their nature, form part of the financial return. For floating rate financial instruments, the effective interest rate coincides with the rate of return prevailing until the next benchmark interest reset date.

Equity instruments whose fair value cannot be determined in a sufficiently objective manner and financial derivatives that have those instruments as their underlying and are settled by delivery of those instruments are measured at acquisition cost adjusted, where appropriate, by any related impairment loss.

The amounts at which the financial assets are recognized represent, in all material respects, the Bank’s maximum exposure to credit risk at each reporting date. In addition, the Bank has received collateral and other credit enhancements to mitigate its exposure to credit risk, which consist mainly of mortgage guarantees, cash collateral, debt and equity instruments, personal guarantees, leased assets, assets acquired under reverse repurchase agreements and securities loans.

The measurement of available-for-sale financial assets is described in further detail in iii. Valuation techniques.

ii. Measurement of financial liabilities

In general, financial liabilities are measured at amortized cost, as defined above, except for those included under Financial liabilities held for trading and Other financial liabilities at fair value through profit or loss and financial liabilities designated as hedged items (or hedging instruments) in fair value hedges, which are measured at fair value.

iii. Valuation techniques

The following table shows a summary of the fair values at December 31, 2016 and 2017, of the financial assets and liabilities indicated below, classified on the basis of the various measurement methods used by the Bank to determine their fair value:


	12/31/2016			12/31/2017
	Published			Published
	Price			Price
	Quotations			Quotations
	in Active			in Active
	Markets –	Internal		Markets –	Internal
	Level 1	Models	Total	Level 1	Models	Total

ASSETS:
Financial assets held for trading	139,869	202,713	342,582	147,784	167,786	315,570
Other financial assets at fair value through profit or loss	—	42,340	42,340	—	51,705	51,705
Available-for-sale financial assets	139,466	15,178	154,644	164,999	743	165,742
Hedging derivatives	—	15,003	15,003	—	15,116	15,116
	279,335	275,234	554,569	312,783	235,350	548,133
LIABILITIES:
Financial liabilities held for trading	166	266,662	266,828	620	239,105	239,725
Other financial liabilities at fair value through profit or loss	—	136,860	136,860	—	120,653	120,653
Hedging derivatives	—	14,287	14,287	—	11,091	11,091
	166	417,809	417,975	620	370,849	371,469

The fair value of the financial instruments is determined, when possible, on the basis of a quoted price in an active market for an identical asset or liability (Level 1). This group includes government debt securities, private-sector debt securities without optional characteristics, derivatives traded in organized markets, shares and short positions.

In cases where price quotations cannot be observed, Management makes its best estimate of the price that the market would set using its own internal models (valuation techniques). These internal models use data based on observable market parameters as significant inputs (Level 2) and, in very specific cases, they use significant inputs not observable in market data (Level 3). The use of observable market data assumes that markets are efficient and therefore the data that is derived therefrom is representative.

The best evidence of the fair value of a financial instrument on initial recognition is the transaction price, unless the fair value of the instrument can be obtained from other market transactions performed with the same or similar instruments or can be measured by using a valuation technique in which the variables used include only observable market data, mainly interest rates.

The objective of valuation techniques is to arrive at a fair value measurement that reflects the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction between market participants at the measurement date.

Still, other internal models use unobservable data as inputs. Examples of such unobservable inputs and assumptions are as follows:

Correlation: Historical correlation between equity prices and exchange rates is assumed for valuing quanto and composite options.

Dividends: The estimation for the dividend used as inputs in the internal models is based on the dividend payments expected from the issuer companies.

Volatility: There is no liquid option market for certain long-term assets. For most Mexican underlying assets, the option market is for up to one year. In the case of the Mexican Stock Exchange Prices and Quotations Index (IPC), there is an option market up to three years. In these cases, Bank’s Management assumes a local volatility model using maturities for which market data exists and extrapolates the curve for unknown terms.

Rate curve for estimating the interest rate index known as the 91‑day Interbank Equilibrium Interest Rate (Tasa de Interés Interbancaria de Equilibrio, or TIIE): there is no liquid market for interest rate swaps (IRS) with 91‑day payment terms. For these fair value measurements, the 28‑day IRS curve is used instead.

Whenever unobservable market data is used in valuation techniques, the valuation is adjusted considering unobservable assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.

The Bank also adjusts the value of some assets when they have very low market trading volume, even when prices are available.

Fair value measurements that incorporate significant unobservable inputs are classified as Level 3. Significant unobservable inputs are defined as inputs for which observable market data are not available and that are significant to the fair value measurement. Such inputs are developed using the best information available about assumptions that market participants would use when pricing the asset or liability.

iv. Valuation of financial instruments

General measurement bases

The Bank has implemented a formal process for systematic valuation and management of financial instruments. The governance scheme for this process distributes responsibilities between two independent areas inside the Bank: Treasury (development, marketing and daily management of financial products and market data) and Risks (on a periodic basis, validation of pricing models and market data, computation of risk metrics, new transactions approval policies, management of market risk and implementation of fair value adjustment policies).

The approval of new products follows a sequence of steps (request, development, validation, integration in corporate systems and quality assurance) before the product is brought into production. This process ensures that pricing systems have been properly reviewed and are stable before they are used.

The related valuation techniques and inputs by asset class are as follows:

Trading and available-for-sale financial assets

The estimated fair value of these financial assets is determined using quoted prices or yield curves provided by a price vendor.

Loans and advances to credit institutions and customers – reverse repurchase agreements

The fair value is estimated by using the discounted cash flow (forward estimation) technique using the interest rates that are currently offered for loans and advances with terms similar to those of borrowers having a similar credit quality.

Short positions, deposits from the Central Bank and deposits from credit institutions and customers – repurchase agreements

The fair value of these financial instruments is calculated by using the discounted cash flow (forward estimation) technique based on the current incremental lending rates for similar types of deposits having similar maturities.

Financial derivatives (assets and liabilities)

The estimated fair value of futures contracts is calculated using the prices quoted on the Derivatives Exchange Markets (Mercado Mexicano de Derivados and Chicago Mercantile Exchange) of identical instruments.

If there are no quoted prices on the market (either direct or indirect) for a derivative instrument, the respective fair value estimates are calculated by using one of the following models and valuation techniques:

i. Non-closed formula solution

In the valuation of financial instruments permitting static hedging (such as loans and receivables, deposits, forwards and swaps), the present value method (forward estimation) is used. This method consists of a) calculating the expected cash flows and b) discounting the expected cash flows at the risk interest rate through the applicable discount factor. Both steps use observable market data (yield curves, foreign exchange spot rates and so forth) which are provided by a market data supplier (price vendor).

ii. Closed-formula solution

The Black-Scholes model and Black model are used for the valuation of plain vanilla options, the first for foreign exchange and securities and the latter for interest rates. These models assume that the underlying price follows a lognormal distribution.

The Monte Carlo method with the local volatility model is the market proxy or reference model to price a wider range of exotic equity products.

The partial differential equation method with the local volatility model is particularly appropriate to price and manage callable products and products including barrier features on a single underlying. This method is quicker, more stable and more precise than the standard Monte Carlo method, but the latter is needed when the underlying is a basket. The local volatility models assume that share and index prices are lognormally distributed and volatility is a deterministic function of time and the market price.

The trinomial trees method is intended for American foreign exchange products, which can be canceled at any time throughout the life of the option. It assumes deterministic interest rates and represents the evolution of the underlying foreign exchange using the Black-Scholes model.

The partial differential equation solver using a mixed volatility model is used for pricing barrier products in foreign exchange. The development of a mixed volatility model was motivated by some very sensitive barrier products (double-no-touch options), which were quoted in the market with prices in between those provided by a local volatility model and a pure stochastic volatility model. The mixed volatility model is a combination of both models, which provides a price between them.

Marketable debt securities (structured notes)

The fair value of these financial instruments is calculated by using the discounted cash flow (forward estimation) technique, based on the current incremental lending rates for similar types of deposits having similar maturities, for the debt obligation component and one of the financial derivatives valuation techniques for the embedded derivative component, that depends on the payoff.

Valuation adjustment for counterparty risk or default risk

The Credit Valuation Adjustment (CVA) is a valuation adjustment to OTC derivatives as a result of the risk associated with the credit exposure assumed with each counterparty.

The CVA is calculated taking into account expected positive exposure with each counterparty in each future period. The CVA for a specific counterparty is equal to the sum of the CVA for all the periods. The following inputs are used to calculate the CVA:

Expected positive exposure: average positive exposure to the counterparty, across all paths, all evaluated on a certain future date using a Monte Carlo method to simulate the future values of the derivatives’ portfolio. Mitigating factors such as collateral and netting agreements are taken into account.

LGD: percentage of final loss assumed in a counterparty credit event /default.

PD: Credit Default Swaps (CDS) are used to infer the probability of default. For cases where there is no market information, probabilities are inferred using a market proxy based on market information from companies in the same industry and with the same external ratings as the counterparty, to ensure best practice.

Discount factor curve.

The debt valuation adjustment (DVA) is a similar valuation adjustment to the CVA but, in this case, it arises as a result of the Bank’s risk assumed by its counterparties in OTC derivatives.

The CVA and DVA recognized at December 31, 2016 amounted to 557 million and 1,658 million, respectively. The CVA and DVA recognized at December 31, 2017 amounted to 370 million and 2,397 million, respectively.

All financial instruments fair values are calculated on a daily basis.

Set forth below are the financial instruments at fair value whose measurement was based on internal models (Level 2 and 3) at December 31, 2016 and 2017.


	Fair			Fair
	Values			Values
	Calculated			Calculated
	Using Internal			Using Internal			Valuation Techniques	Key Inputs
	Models at			Models at
	12/31/2016			12/31/2017
	Level 2	Level 3	Total	Level 2	Level 3	Total

ASSETS:
Financial assets held for trading:	202,541	172	202,713	167,535	251	167,786

Debt instruments	2,697	172	2,869	2,593	—	2,593	Forward Estimation (non closed formula)	Interest rate yield curve
Trading derivatives:

Interest rate options	1,698	—	1,698	1,339	—	1,339	Black model (closed-form solution)	Interest rate yield curve and implied volatility surface.

Market index options:	871	—	871	581	—	581

European options	839	—	839	548	—	548	Black-Scholes model (closed-form solution)	Interest rate yield curves, quoted equity prices and index levels, implied volatility surface and dividends estimation.

Asian (Single underlying Quanto)	20	—	20	18	—	18	Local volatility model with partial differential equation method	Interest rate yield curves, quoted equity prices and index levels, implied volatility surface, historical correlations and dividends estimation.

Best of options (Basket)	12	—	12	15	—	15	Local volatility model with Monte Carlo method	Interest rate yield curves, equity prices and index levels, implied volatility surface, historical correlations and dividends estimation

Exchange rate options:	383	—	383	1,885	172	2,057

American forwards	6	—	6	23	—	23	Black and Scholes model with trinomial tree method	Interest rate yield curves, quoted exchange rates and implied volatility surface

American Barrier & Touch options	—	—	—	39	—	39	Mixed volatility model with partial differential equation method	Interest rate yield curves, quoted exchange rates and implied volatility surface

European options	377	—	377	1,823	172	1,995	Black-Scholes model (closed-form solution)	Interest rate yield curves, quoted exchange rates and implied volatility surface

Swaps	190,199	—	190,199	155,799	23	155,822	Forward Estimation (non-closed formula)	Interest rate yield curve and quoted exchange rates

Index and securities futures	3	—	3	93	—	93	Forward Estimation (non-closed formula)	Interest rate yield curve and quoted exchange rates

Interest rate futures	6	—	6	—	—	—	Forward Estimation (non-closed formula)	Interest rate yield curve

Exchange rate futures	6,684	—	6,684	5,245	56	5,301	Forward Estimation (non-closed formula)	Interest rate yield curve and quoted exchange rates

Other financial assets at fair value through profit or loss:	42,340	—	42,340	51,705	—	51,705

Loans and advances to credit institutions – Reverse repurchase agreements	37,831	—	37,831	46,087	—	46,087	Forward Estimation (non-closed formula)	Interest rate yield curve

Loans and advances to customers – Reverse repurchase agreements	4,509	—	4,509	5,618	—	5,618	Forward Estimation (non-closed formula)	Interest rate yield curve

Financial assets available-for-sale:	15,178	—	15,178	743	—	743

Debt instruments	15,083	—	15,083	675	—	675	Forward Estimation (non-closed formula)	Interest rate yield curve

Equity instruments	95	—	95	68	—	68	Other	Value of shareholders’ equity

Hedging derivatives:	15,003	—	15,003	15,116	—	15,116

Swaps	15,003	—	15,003	12,727	—	12,727	Forward Estimation (non-closed formula)	Interest rate yield curve and quoted exchange rates

Exchange rate forwards	—	—	—	2,389	—	2,389	Forward Estimation (non-closed formula)	Interest rate yield curve and quoted exchange rates

	275,062	172	275,234	235,099	251	235,350


	Fair			Fair
	Values			Values
	Calculated			Calculated
	Using Internal			Using Internal
	Models at			Models at			Valuation
	12/31/2016			12/31/2017			Techniques	Key Inputs
	Level 2	Level 3	Total	Level 2	Level 3	Total

LIABILITIES:
Financial liabilities held for trading:
	266,662	—	266,662	238,747	358	239,105

Trading derivatives:

Interest rate options	1,904	—	1,904	1,197	—	1,197	Black model (closed-form solution)	Interest rate yield curve and implied volatility surface.

Market index options:	340	—	340	298	—	298

European	69	—	69	163	—	163	Black-Scholes model (closed-form solution)	Interest rate yield curves, quoted equity prices, index levels, implied volatility surface and dividends estimation.

Auto-callable	264	—	264	129	—	129	Local volatility model with partial differential equation method	Interest rate yield curves, quoted equity prices and index levels, implied volatility surface, historical correlations and dividends estimation.

Asian (Single underlying Quanto)	7	—	7	6	—	6	Local volatility model with partial differential equation method	Interest rate yield curves, quoted equity prices and index levels, implied volatility surface, historical correlations and dividends estimation.

Exchange rate options:	573	—	573	2,397	198	2,595

American forwards	116	—	116	53	—	53	Black and Scholes model with trinomial tree method	Interest rate yield curves, quoted exchange rates and implied volatility surface

European options	431	—	431	2,238	198	2,436	Black-Scholes model with (closed-formula solution)	Interest rate yield curves, quoted exchange rates and implied volatility surface

American barrier and touch options	9	—	9	47	—	47	Mixed volatility model with partial differential equation method	Interest rate yield curves, quoted exchange rates and implied volatility surface

American options	17	—	17	59	—	59	Black-Scholes model (closed-form solution)	Interest rate yield curves, quoted exchange rates and implied volatility surface

Swaps	196,485	—	196,485	161,389	—	161,389	Forward Estimation (non- closed formula solution)	Interest rate yield curvescurve and quoted exchange rates


Index and securities futures	4	—	4	90	—	90	Forward Estimation (non closed formula)	Interest rate yield curves,curve and quoted equity and index levels exchange rates

Interest rate futures	28	—	28	—	—	—	Forward Estimation (non closed formula)	Interest rate yield curve

Exchange rate futures	6,190	—	6,190	4,933	160	5,093	Forward Estimation (non closed formula)	Interest rate yield curve and quoted exchange rates
				.
Short positions:

Debt instruments	61,138	—	61,138	68,443	—	68,443	Forward Estimation (non- closed formula solution)	Interest rate yield curve

Other financial liabilities at fair value through profit or loss:	136,860		136,860	120,653		120,653

Deposits from the Central Bank – Repurchase agreements	15,479	—	15,479	22,417	—	22,417	Forward Estimation (non closed formula)	Interest rate yield curve

Deposits from credit institutions – Repurchase agreements	25,155	—	25,155	5,942	—	5,942	Forward Estimation (non closed formula)	Interest rate yield curve

Customer deposits – Repurchase agreements	83,891	—	83,891	81,790	—	81,790	Forward Estimation (non closed formula)	Interest rate yield curve

Marketable debt securities	12,335	—	12,335	10,504	—	10,504	Present value (non-closed formula solution) and Black-Sholes model with closed-formula solution.	Interest rate yield curve, quoted equity prices and index levesl, implied volatility surface, historical correlations and dividens estimation

Hedging derivatives:	14,287	—	14,287	11,091	—	11,091

Swaps	7,969	—	7,969	10,370	—	10,370	Forward Estimation (non closed formula)	Interest rate yield curve and quoted exchange rates

Exchange rate forwards	6,318	—	6,318	721	—	721	Forward Estimation (non closed formula)	Interest rate yield curve and quoted exchange rates
	417,809	—	417,809	370,491	358	370,849

Some of the financial instruments of the fair-value hierarchy have identical or similar offsetting exposures to certain inputs, but in accordance with IFRS, are presented as gross assets and liabilities in the consolidated balance sheet.

The measurements derived using the valuation techniques might have been different had other methods or assumptions been used with respect to interest rate risk, credit risk and foreign currency risk spreads, or their related correlations and volatilities. Nevertheless, Bank’s Management believes that the fair value of the financial assets and liabilities recognized in the consolidated balance sheet and the gains and losses arising from these financial instruments are reasonably stated.

Financial instruments categorized in Level 3

Set forth below are the Bank’s main financial instruments measured using unobservable market data as significant inputs of the internal models (Level 3):

As of December 31, 2017, the financial assets held for trading categorized in Level 3 are the structure denominated as “Red Compartida” and two Cross Currency Swaps (CCS) USD/Mexican Peso (MXN) with maturity of twenty two years.

The structure denominated as “Red Compartida” is composed of foreign currency exchange (Fx) forwards and plain vanilla Fx options over USD/MXN with maturity from two to five years. For the Fx options there is a substantial risk of uncertainty in the market data used for the valuation, specifically in the long-term volatility, because the USD/MXN options market in these terms may not have the necessary market liquidity. The lack of sufficient liquidity make the Fx options to be valued using an unobservable input, thus “Red Compartida” should be categorized as Level 3.

During the last quarter of 2017, two CCS USD/MXN (Nominal USD 100 MM) were traded at twenty two years which should be considered as Level 3 due to illiquidity above twenty years of these products.

As of December 31, 2016, the financial assets held for trading categorized in Level 3 (debt and equity instruments) are convertible bonds issued by Cementos Mexicanos, S.A.B. de C.V. (CEMEX). This hybrid instrument was valued using partial differential equation solver given the embedded equity option (whose underlying asset was CEMEX.CPO, the shares listed on Mexican Stock Exchange) on the debt instrument. Because the long-term implied volatility was not quoted directly in an active market or otherwise capable of estimates that were exclusively based on observable inputs and assumptions, this financial asset was classified as Level 3.

The following table provides a reconciliation of the movement between opening and closing balances of Level 3 financial instruments, measured at fair value using a valuation technique with significant unobservable inputs:


		Assets
	Debt and Equity	Trading
	Instruments	derivatives	Total

Balance at January 1, 2015	903	—	903
Total gains/losses recognized in the consolidated income statement:
Gains/(losses) on financial assets and liabilities (net)	13	—	13
Purchases	1	—	1
Sales	(647)	—	(647)
Settlements	(51)	—	(51)
Balance at December 31, 2015	219	—	219
Total gains/losses recognized in the consolidated income statement:
Gains/(losses) on financial assets and liabilities (net)	73	—	73
Purchases	—	—	—
Sales	(102)	—	(102)
Settlements	(18)	—	(18)
Balance at December 31, 2016	172	—	172
Total gains/losses recognized in the consolidated income statement:
Gains/(losses) on financial assets and liabilities (net)	(13)	91	78
Purchases	—	—	—
Sales	(143)	—	(143)
New issuances	—	160	160
Settlements	(16)	—	(16)
Balance at December 31, 2017	—	251	251


		Liabilities
	Debt and Equity	Trading
	Instruments	derivatives	Total

Balance at December 31, 2016	—	—	—
Total gains/losses recognized in the consolidated income statement:
Gains/(losses) on financial assets and liabilities (net)	—	(9)	(9)
Purchases	—	—	—
Sales	—	—	—
New issuances	—	(349)	(349)
Settlements	—	—	—
Balance at December 31, 2017	—	(358)	(358)

Unobservable inputs used in measuring fair value

The table below sets out information about significant unobservable inputs used at December 31, 2017 in measuring financial instruments categorized as Level 3 in the fair value hierarchy:

Significant

Range of Estimates

Fair value Measurement

Valuation

Unobservable

(weighted-average)

Sensitivity to

Financial Instrument

Fair value

Technique

Input

for Unobservable Input

Unobservable Inputs

Cross Currency Swaps

Forward Estimation (non closed formula)

Long term MXN rates

Bid Offer Spread
IRS TIIE 2bp - 6bp (3bp)
CCS USD/MXN 3 bp-10bp (4bp)

A significant increase in MXN rates would result in a lower fair value.

Red Compartida

(130)

Black-Scholes model (closed-form solution)

Long term Fx USD/MXN volatility

11%-21% (15.7%)

A significant increase in volatility would result in a lower fair value.

Although the Bank believes that its estimates of fair value are appropriate, the use of different inputs could lead to different measures of fair value. As of December 31, 2017, the potential impact on the consolidated income statement of changing the main inputs used for the measurement of Level 3 financial instruments for other inputs, taking the highest (most favorable input) or lowest (least favorable) value of the range deemed reasonably possible, would be as follows:


	Potential Impact on Consolidated
	Income Statement as of
	December 31, 2017
	Most	Least
	Favorable	Favorable
	Input	Input

ASSETS:
Cross Currency Swaps	16.6	(16.6)
LIABILITIES:
Red Compartida	6.9	(41.8)

Cross Currency Swaps

The least favorable scenario assumed the following:

The MXN market rates (IRS TIIE and X-CCY USD/MXN) needed to valuation were moved up 6 basis points (bps) and 10 bps accordingly. The scenarios were determined by the following: 0.95 percentil over a 1 year historical period of the difference between the bid and offer quotations of these market rates divided by two.

The most favorable scenario assumed the following:

The MXN market rates (IRS TIIE and X-CCY USD/MXN) needed to valuation were moved down 6 bps and 10 bps accordingly.

Red Compartida

The least favorable scenario assumed the following:

The volatility of the underlying asset of the long term Fx USD/MXN options at its maturity moved from 15.7% to 19.42%.

The volatility used as input for the internal model (15.7%) is an extrapolation of the observable volatility surface of a shorter-term option market of the underlying, provided by the local price vendor. The scenario was based on two factors: the difference between the bid and offer quotations of these options divided by two and the 0.95% percentil of the movement price distribution.

The most favorable scenario assumed the following:

The volatility of the underlying asset of the long term Fx USD/MXN options at its maturity moved from 15.7% to 15.1%.

v. Sensitivity analysis

As an alternative to sensitivity analysis, the Bank uses a Value at Risk (VaR) technique. A detailed explanation about VaR technique and the main assumptions incorporated therein are described in Note 47. The VaR amounts as of December 31, 2017, including all financial instruments in the trading book position of the Bank are as follows:


	Average	High	Low	12/31/2017

All financial instruments	95.06	146.43	57.61	128.61
By category:
Instruments sensitive to interest rate	96.39	144.09	55.74	125.20
Instruments sensitive to equity market prices	4.64	16.83	1.36	5.07
Instruments sensitive to foreign currency exchange rates	50.83	101.46	8.16	25.34
Instruments sensitive to volatility movements	11.57	26.22	3.97	16.13

The Bank’s VaR should be interpreted in light of the limitations of the methodologies. These limitations include the following:

Historical data may not provide the best estimate of the joint distribution of risk factor changes in the future and may fail to capture the risk of possible extreme adverse market movements, which have not occurred in the historical window used in the calculations.

VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day.

The Bank largely computes the VaR of the trading portfolios at the close of business and positions may change substantially during the course of the trading day.

VaR using a 99 percent confidence level does not reflect the extent of potential losses beyond that percentile.

These limitations and the nature of the VaR measure mean that the Bank can neither guarantee that losses will not exceed the VaR amounts indicated nor that losses in excess of the VaR amounts will not occur more frequently than once in 100 business days.

vi. Recognition of fair value changes

Changes in the fair value of certain financial assets and liabilities subject to those changes are recognized, either in the consolidated income statement or in the consolidated other comprehensive income. A distinction is made between the changes resulting from the accrual of interest and similar items which are recognized under Interest income and similar income or Interest expenses and similar charges, as appropriate, and those arising for other reasons which are recognized at their net amount under Gain/(losses) on financial assets and liabilities (net).

Adjustments due to changes in fair value arising from:

Available-for-sale financial assets are recognized temporarily in the Bank’s consolidated other comprehensive income under Valuation adjustments - Available-for-sale financial assets, unless they relate to exchange differences arising on available-for-sale non-monetary items, in which case they are recognized also in Valuation adjustments in the consolidated other comprehensive income. Exchange differences arising on available-for-sale monetary financial assets are recognized under Gains/(losses) on financial assets and liabilities (net) in the consolidated income statement.

Items charged or credited to Valuation adjustments - Available-for-sale financial assets remain in the Bank’s consolidated equity until the asset giving rise to them is impaired or derecognized, at which time they are recognized in the consolidated income statement.

vii. Hedging transactions

The Bank uses derivatives for the following purposes: (i) to facilitate these instruments to customers who request them in the management of their market and credit risks (trading derivatives); (ii) to use these derivatives in the management of the risks of the Bank entities’ own positions and assets and liabilities (hedging derivatives); and (iii) to obtain gains from changes in the prices of these derivatives (trading derivatives).

Derivatives that do not qualify for hedge accounting are treated for accounting purposes as trading derivatives.

A derivative qualifies for hedge accounting if all the following conditions are met:

The derivative hedges one of the following three types of exposure:

Changes in the fair value of assets and liabilities due to fluctuations in, among others, the interest rate and/or exchange rate to which the position or balance to be hedged is subject (fair value hedge);

Changes in the estimated cash flows arising from financial assets and liabilities, commitments and highly probable forecasted transactions (cash flow hedge); and

The net investment in a foreign operation (hedge of a net investment in a foreign operation).

It is effective in offsetting exposure inherent in the hedged item throughout the expected term of the hedge, which means that:

At the date of arrangement, the hedge is expected, under normal conditions, to be highly effective (prospective effectiveness).

There is sufficient evidence that the hedge was effective during the whole life of the hedged item (retrospective effectiveness). To this end, the Bank checks that the results of the hedge were within a range of 80% to 125% of the results of the hedged item.

There must be adequate documentation evidencing the specific designation of the derivative to hedge certain balances or transactions and how this hedge was expected to be achieved and measured, provided that this is consistent with the Bank’s Management of its own risks.

The changes in value of financial instruments qualifying for hedge accounting are recognized as follows:

In fair value hedges, the gains or losses arising on both the hedging instruments and the hedged items attributable to the type of risk being hedged are recognized directly in the consolidated income statement.

In cash flow hedges, the effective portion of the change in value of the hedging instrument is recognized in the consolidated other comprehensive income under Valuation adjustments - Cash flow hedges until the forecast transactions occur, when it is recognized in the consolidated income statement, unless, if the forecast transactions result in the recognition of non-financial assets or liabilities, it is included in the cost of the non-financial asset or liability.

In hedges of a net investment in a foreign operation, the gains or losses attributable to the portion of the hedging instruments qualifying as an effective hedge are recognized temporarily in the consolidated other comprehensive income under Valuation adjustments - Hedges of net investments in foreign operations until the gains or losses on the hedged item are recognized in the consolidated income statement.

The ineffective portion of the gains or losses on the hedging instruments of cash flow hedges and hedges of a net investment in a foreign operation are recognized directly under Gain/(losses) on financial assets and liabilities in the consolidated income statement.

If a derivative designated as a hedge no longer meets the requirements described above due to expiration, ineffectiveness or for any other reason, the derivative is classified for accounting purposes as a trading derivative.

When fair-value hedge accounting is discontinued, the adjustments previously recognized on the hedged item are reclassified to the consolidated income statement at the effective interest rate recalculated at the date of hedge discontinuation. The adjustments must be fully amortized at maturity.

When cash flow hedges are discontinued, any cumulative gain or loss on the hedging instrument recognized in the consolidated other comprehensive income under Valuation adjustments - Cash flow hedges (from the period when the hedge was effective) remains in this consolidated equity item until the forecast transaction occurs, at which time it is recognized in the consolidated income statement, unless the transaction is no longer expected to occur, in which case the cumulative gain or loss is recognized immediately in the consolidated income statement.

vii. Embedded derivatives in hybrid financial instruments

Embedded derivatives in other financial instruments or in other host contracts are accounted for separately as derivatives if their risks and characteristics are not closely related to those of the host contracts, provided that the host contracts are not classified as Other financial assets/liabilities at fair value through profit or loss or as Financial assets/liabilities held for trading.

Banco Santander (Mexico) S.A., Institucion de Banca Multiple, Grupo Financiero Santander Mexico | CIK:0001698287 |

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