Note 7.1 Financial Instruments

The fair value hierarchy of financial instruments

There was no transfer between individual levels of the fair value hierarchy of financial instruments, in either the reporting or the comparable periods, nor was there any change in the classification of instruments as a result of a change in the purpose or use of these instruments.

Gains/(losses) on financial instruments

Note 7.2 Derivatives

Hedging derivatives – open items as at the end of the reporting period

Trade derivatives – open items as at the end of the reporting period

As at 31 December 2018, counterparty credit risk (CVA – credit value adjustment, for assets) and own credit risk (DVA – debit value adjustment, for liabilities) were not recognised in the measurement of derivatives (hedging and trade) due to their immateriality.

The fair value measurement of derivatives was classified under level 2 of the fair value hierarchy (i.e. measurement which applies observable inputs other than quoted prices):

• In the case of forward currency purchase or sell transactions, the Company uses forward prices from the maturity dates of individual transactions to determine their fair value. The forward price for currency exchange rates is calculated on the basis of fixing and appropriate interest rates. Interest rates for currencies and the volatility ratios for exchange rates are taken from Reuters. The standard Garman-Kohlhagen model is used to measure European options on currency markets.
• In the case of forward commodity purchase or sell transactions, the Company uses forward prices from the maturity dates of individual transactions to determine their fair value. At the end of the reporting period, in the case of copper, official closing prices from the London Metal Exchange are used, and with respect to silver and gold, the fixing price set by the London Bullion Market Association. Volatility ratios and forward price curves given by the Reuters system are used to calculate derivatives at the end of the reporting period. Levy approximation to the Black-Scholes model is used for Asian options pricing on commodity markets.

The impact of derivatives and hedging transactions on the items of the statement of profit or loss and on the statement of comprehensive income is presented below:

Note 7.3 Other financial instruments measured at fair value

The measurement of listed shares is classified to level 1 of the fair value hierarchy (i.e. measurement is based on the prices of these shares listed on an active market at the measurement date), while the measurement of unquoted shares is classified to level 2 (i.e. measurement based on non-observable data).

Due to investments in listed companies, the Company is exposed to price risk. Changes in the listed share prices of these companies resulting from the existing macroeconomic situation may have a significant impact on the level of other comprehensive income and on the accrued amount recognised in equity.

The following table presents the sensitivity analysis of listed companies shares to price changes.

Sensitivity analysis for significant types of market risk to which the Company is exposed presents the estimated impact of potential changes in individual risk factors (at the end of reporting period) on profit or loss and other comprehensive income.

Potential movements in share prices at the end of the reporting period were determined at the level of maximum deviations in a given year.

Note 7.4 Other non-current financial instruments measured at amortised cost

Details regarding measurement of the provision for the decommissioning costs of mines and other technological facilities is described in Note 9.4.

Note 7.5 Financial risk management

In the course of its business activities the Company is exposed to the following main financial risks:

• market risks:
• ocommodity risk,
• orisk of changes in foreign exchange rates,
• orisk of changes in interest rates,
• oprice risk related to investments in shares of listed companies (Note 7.3),
• credit risk, and
• liquidity risk (the process of financial liquidity management is described in Note 8).

The Company’s Management Board manages identified financial risk factors in a conscious and responsible manner, using the Market Risk Management Policy, the Financial Liquidity Management Policy and the Credit Risk Management Policy adopted by the Company. Understanding the threats arising from the Company's exposure to risk and maintaining an appropriate organisational structure and procedures enable an effective achievement of tasks. The Company identifies and measures financial risk on an ongoing basis, and also takes actions aimed at minimising their impact on the financial position.

The process of financial risk management in the Company is supported by the work of the Market Risk Committee, the Financial Liquidity Committee and the Credit Risk Committee.

Note 7.5.1 Market risk

The market risk to which the Company is exposed to is understood as the possible occurrence of negative impact on the Company's results arising from changes in the market prices of commodities, exchange rates and interest rates, as well as the share prices of listed companies.

Note 7.5.1.1 Principles and techniques of market risk management

The Company actively manages the market risk to which it is exposed.
In accordance with the adopted policy, the goals of the market risk management process are as follows:

• limit volatility in the financial result;
• increase the probability of meeting budget targets,
• decrease the probability of losing financial liquidity,
• maintain the financial health of the Company; and,
• support the process of strategic decision making related to investing, including financing sources.

The objectives of market risk management should be considered as a whole, and their realisation is determined mainly by the Company’s internal situation and market conditions. Actions and decisions concerning market risk management in the Company should be analysed in the context of the KGHM Polska Miedź S.A. Group’s global exposure to market risk.

The primary technique used in market risk management is the utilisation of hedging strategies involving derivatives. Natural hedging is also used.

Taking into account the potential scope of their impact on the Company’s results, market risk factors were divided into the following groups:

The Company manages market risk by applying various approaches to particular, identified exposure groups. The Company considers the following factors when selecting hedging strategies or restructuring hedging positions: current and forecasted market conditions, the internal situation of the Company, the effective level and cost of hedging, and the impact of the minerals extraction tax

The Company applies an integrated approach to managing the market risk to which it is exposed. This means a comprehensive approach to market risk, and not to each element individually. An example is the hedging transactions on the currency market, which are closely related to contracts entered into on the metals market. The hedging of metals sales prices determines the probability of achieving specified revenues from sales in USD, which represent a hedged position for the strategy on the currency market.

The Company executes derivative transactions only if it has the ability to assess their value internally, using standard pricing models appropriate for a particular type of derivative, and which can be traded without significant loss of value with a counterparty other than the one with whom the transaction was initially entered into. In evaluating the market value of given instruments, the Company uses information obtained from leading information services, banks, and brokers.

The Company's internal policy, which regulates market risk management principles, permits the use of the following types of instruments:

• swaps;
• forwards and futures;
• options; and
• structures combining the above instruments.

The instruments applied may be, therefore, either of standardised parameters (publicly traded instruments) or non-standardised parameters (over-the-counter instruments). Primarily applied are cash flow hedging instruments meeting the requirements for effectiveness as understood by hedge accounting. The effectiveness of the financial hedging instruments applied by the Company in the reporting period is continually monitored and assessed (details in Note 7.2 Derivatives – accounting policies).

The economic relationship between a hedging instrument and a hedged position is based on the sensitivity of the value of the position to the same market factors (metals prices, exchange rates or interest rates) and on matching appropriate key parameters of the hedging instrument and the hedged position (volume/notional amount, maturity date).

The hedge ratio of the established hedging relationship is set at the amount ensuring the effectiveness of the relationship and is consistent with the actual volume of the hedged position and the hedging instrument. Sources of potential ineffectiveness of the relationship arise from a mismatch of the parameters of the hedged instrument and the hedged position (e.g. the notional amount, maturity, base instrument, impact of credit risk). When structuring a hedging transaction, the Company aims to ensure a maximal match between these parameters to minimise the sources of ineffectiveness.

The Company quantifies its market risk exposure using a consistent and comprehensive measure. Market risk management is supported by simulations (such as scenario analysis, stress-tests, backtests) and calculated risk measures. The risk measures being used are mainly based on mathematical and statistical modelling, which uses historical and current market data concerning risk factors and takes into consideration the current exposure of the Company to market risk.

One of the measures used as an auxiliary tool in making decisions in the market risk management process is EaR - Earnings at Risk. This measure indicates the lowest possible level of profit for the period for a selected level of confidence (for example, with 95% confidence the profit for a given year will be not lower than…). The EaR methodology enables the calculation of profit for the period incorporating the impact of changes in market prices of copper, silver and foreign exchange rates in the context of budgeted results.

Due to the risk of production cutbacks (for example because of force majeure) or failure to achieve planned foreign currency revenues, as well as purchases of metals contained in purchased materials, the Company has set limits with respect to commitment in derivatives:

• up to 85% of planned, monthly sales volume of copper, silver and gold from own concentrates, while: for copper and silver - up to 50% with respect to instruments which are obligations of the Company (for financing the hedging strategy), and up to 85% with respect to instruments representing the rights of the Company.
• up to 85% of planned, monthly revenues from the sale of products from own concentrates in USD or of the monthly, contracted net currency cash flows in case of other currencies. For purposes of setting the limit, expenses for servicing the debt denominated in USD decrease the nominal amount of exposure to be hedged.

These limits are in respect both of hedging transactions as well as of the instruments financing these transactions.

The maximum time horizon within which the Company decides to limit market risk is set in accordance with the technical and economic planning process and amounts to 5 years, whereas in terms of interest rate risk, the time horizon reaches up to the maturity date of the long-term financial liabilities of the Company.

With respect to the risk of changes in interest rates, the Company has set a limit of commitment in derivatives of up to 100% of the debt’s nominal value in every interest period, as stipulated in the signed agreements.

Note 7.5.1.2 Commodity risk

The Company is exposed to the risk of changes in the prices of the metals it sells: copper, silver, gold and lead. The price formulas used in physical delivery contracts are mainly based on average monthly quotations from the London Metal Exchange for copper and lead and from the London Bullion Market Association for silver and gold. The Company’s commercial policy is to set the price base for physical delivery contracts as the average price of the appropriate future month.

The permanent and direct link between sales proceeds and metals prices, without similar relationships on the expenditures side, results in a strategic exposure. In turn, operating exposure is a result of possible mismatches in the pricing of physical contracts with respect to the Company’s benchmark profile, in particular in terms of the reference prices and the quotation periods.

On the metals market, the Company has a so-called long position, which means it has higher sales than purchases. The analysis of the Company’s exposure to market risk should be performed by deducting from the volume of metals sold the amount of metal in purchased materials.

The Company’s strategic exposure to the risk of changes in the price of copper and silver in years 2017-2018 is presented in the table below.

The notional amount of copper price hedging strategies settled in 2018 represented approx. 19% (in 2017: 23%) of the total sales of this metal realised by the Company (it represented approx. 25% of net sales in 2018 and 32% in 2017). In 2018 revenues from silver sales were not hedged by derivatives.

With respect to strategic management of market risk in 2018, the Company implemented copper price hedging transactions with a total notional amount of 126 thousand tonnes and a maturity period from July 2018 to December 2020 (of which: 114 thousand tonnes were in respect of hedging revenues from sales of copper in years 2019-2020). Collar and seagull options structures were implemented (Asian options). In 2018 the Company did not implement derivatives transactions on the silver market.

In addition, in 2018 the Company began the management of a net trading position in order to react to changes in contractual agreements with customers, non-standard pricing terms in metals sales and purchases of copper-bearing materials. In the fourth quarter of 2018 QP adjustment swap transactions were entered into on the copper and gold markets with maturity to June 2019.

As a result, as at 31 December 2018 the Company held open derivatives transactions on the copper market for 168 thousand tonnes (of which: 156 thousand tonnes came from strategic management of market risk, while 12 thousand tonnes came from the management of a net trading position).

The condensed table of open derivatives transactions held by the Company on the copper market as at 31 December 2018, entered into as part of the strategic management of market risk, is presented below (the hedged notional in the presented periods is allocated evenly on a monthly basis).

The sensitivity analysis of the Company for risk of changes in copper prices as at 31 December 2018 is presented in the table below:

The sensitivity analysis of the Company for risk of changes in copper prices as at 31 December 2017 is presented in the table below

In order to determine the potential movements in metals prices for purposes of sensitivity analysis of commodity risk factors (copper), the mean reverting Schwarz model (the geometrical Ornstein-Uhlenbeck process) was used.

Note 7.5.1.3 Risk of changes in foreign exchange rates

Regarding the risk of changes in foreign exchange rates, the following types of exposures were identified:

• transaction exposure related to the volatility of cash flows in the base currency; and
• exposure related to the volatility of selected items of the statement of financial position in the base (functional) currency.

The transaction exposure to currency risk derives from cash flow-generating contracts, whose values expressed in the base (functional) currency depend on future levels of exchange rates of the foreign currencies with respect to the base currency (for KGHM Polska Miedź S.A. it is the Polish zloty). Cash flows exposed to currency risk may possess the following characteristics:

• denomination in the foreign currency – cash flows are settled in foreign currencies other than the functional currency; and
• indexation in the foreign currency – cash flows may be settled in the base currency, but the price (i.e. of a metal) is set in a different foreign currency.

The key source of transaction exposure to currency risk in the Company’s business operations are the proceeds from sales of products (with respect to metals prices, processing and producer margins).

The Company’s exposure to currency risk derives also from items in the statement of financial position denominated in foreign currencies, which under the existing accounting regulations must be, upon settlement or periodic valuation, translated by applying the current exchange rate of the foreign currencies versus the base (functional) currency. Changes in the carrying amounts of such items between valuation dates result in the volatility of profit or loss for the period or of other comprehensive income.

Items in the statement of financial position which are exposed to currency risk include in particular:

• trade receivables and trade payables related to purchases and sales denominated in foreign currencies;
• financial receivables due to loans granted in foreign currencies;
• financial liabilities due to borrowings in foreign currencies;
• cash and cash equivalents in foreign currencies; and
• derivatives on metals market.

As for the currency market, the notional amount of settled transactions hedging revenues from metals sales amounted to approx. 32% (in 2017: 26%) of the total revenues from sales of copper and silver realised by the Company in 2018.

In 2018 the Company implemented transactions hedging against a change in the USD/PLN exchange rate with a notional amount of USD 1 710 million and maturity falling from April 2018 to December 2020 (of which: transactions hedging revenues in the amount of USD 1 080 million were in respect of the period from January 2019 to December 2020). On the currency market put options (European options) were purchased and collar options structures (European options) were entered into.

 As at 31 December 2018, the Company held an open hedging position in derivatives for USD 1 260 million of planned revenues from sales of metals.

The condensed table of open transactions in derivatives on the currency market as at 31 December 2018 is presented below (the hedged notional in the presented periods is allocated evenly on a monthly basis).

As for managing currency risk which may arise from bank loans, the Company applies natural hedging by borrowing in the currency in which it has revenues. As at 31 December 2018, following their translation to PLN, the bank loans and the investment loans which were drawn in USD amounted to PLN 7 655 million (as at 31 December 2017: PLN 6 935 million).

The currency structure of financial instruments exposed to currency risk (changes in the USD/PLN, EUR/PLN and GBP/PLN exchange rates) is presented in the table below. An analysis for the remaining currencies is not presented due to its immateriality.

* Transactions on the commodities and interest rate markets which are denominated in USD and translated to PLN at the exchange rate as at the end of the reporting period are presented in the item “derivatives”, in the column “USD million”, while the column “total PLN million” also includes the fair value of derivatives on the currency market which are denominated solely in PLN.

The sensitivity analysis of the Company for currency risk as at 31 December 2018 is presented in the table below:

The sensitivity analysis of the Company to currency risk as at 31 December 2017 is presented in the table below:

In order to determine the potential movements in the USD/PLN, EUR/PLN and GBP/PLN exchange rates for sensitivity analysis purposes, the Black-Scholes model (the geometrical Brownian motion) was used.

Note 7.5.1.4 Interest rate risk

In 2018 the Company was exposed to the risk of changes in interest rates due to loans granted, investing free cash, participating in a cash-pooling service and borrowing.

Positions with variable interest rates expose the Company to the risk of changes in cash flow from a given position as a result of changes in interest rates (i.e. it has an impact on the interest costs or income recognised in the profit or loss). Positions with fixed interest rates expose the Company to the risk of fair value changes of a given position, excluding items measured at amortised cost, for which the change in fair value does not affect their measurement and profit or loss.

The main items which are exposed to interest rate risk are presented below.

* Presented amounts include cash accumulated in special purpose funds: Mine Closure Fund, Tailings Storage Facility Restoration Fund and Social Fund
** Presented amounts include the preparation fee paid which decreases financial liabilities due to bank loans 
*** Presented in the net amount (receivables due to participation in cash pooling services less liabilities)

In 2018, the Company did not implement any new derivative transactions hedging against an increase of the interest rate (LIBOR USD). However, in the first half of 2018 the Company drew a bank loan in the amount of USD 150 million, based on a fixed interest rate and the first instalment, in the amount of USD 65 million, of the loan granted in December 2017 by the European Investment Bank, also based on a fixed interest rate, and therefore hedging itself against the interest rate risk (natural hedging).

A condensed table of open transactions in derivatives on the interest rate market as at 31 December 2018 is presented below (maturity dates of options fall at the end of subsequent quarters).

The table below presents the sensitivity analysis of the Company to interest rate risk with respect to positions with variable interest rates.

Note 7.5.1.5 Impact of hedge accounting on the financial statements

The following table contains information on changes in the fair value of derivatives and of loans designated as hedging instruments under hedge accounting, as well as corresponding changes in the fair value of hedged positions during the reporting period, being the basis for recognising the effective and ineffective portions of changes in the fair value of hedging instruments as at 31 December 2018.

The table below presents information on the impact of hedge accounting on profit or loss and other comprehensive income.

The following table contains information on changes in other comprehensive income in the period in connection with the application of hedge accounting.

Note 7.5.2 Credit risk

Credit risk is defined as the risk that the Company’s counterparties will not be able to meet their contractual liabilities and involves three main areas:

• the creditworthiness of the customers with whom physical sale transactions are undertaken;
• the creditworthiness of the financial institutions (banks/brokers) with whom, or through whom, hedging transactions are undertaken, as well as those in which free cash and cash equivalents are deposited; and
• the financial standing of subsidiaries - borrowers.

In particular, the Company is exposed to credit risk due to:

• cash and cash equivalents and deposits;
• derivatives;
• trade receivables;
• loans granted (Note 6.2);
• guarantees granted (Note 8.6); and
• other financial assets.

Note 7.5.2.1 Credit risk related to cash, cash equivalents and bank deposits

The Company periodically allocates free cash in accordance with the requirements to maintain financial liquidity and limit risk and in order to protect capital and maximise interest income.

As at 31 December 2018, the total amount of free and restricted cash and cash equivalents of PLN 627 million was held in bank accounts and in short-term deposits. The detailed structure of cash and cash equivalents is presented in note 8.5.

All entities with which deposit transactions are entered into by the Company operate in the financial sector. These are solely banks registered in Poland or operating in Poland as branches of foreign banks, which belong to European and American financial institutions with the highest, medium-high and medium ratings, an appropriate level of equity and a strong, stable market position. Credit risk in this regard is continuously monitored through the on-going review of the financial standing and by maintaining an appropriately low level of concentration of resources in individual financial institutions.

The following table presents the level of concentration of cash and deposits, with the assessed creditworthiness of the financial institutions*:

*Weighed by amount of deposits.

Note 7.5.2.2 Credit risk related to derivatives transactions

All entities with which derivative transactions are entered into by the Company operate in the financial sector.

The following table presents the structure of ratings of the financial institutions with whom the Company had derivatives transactions, representing exposure to credit risk*.

* Weighted by positive fair value of open and unsettled derivatives.

Taking into consideration the fair value of open derivatives transactions entered into by the Company and the fair value of unsettled derivatives, as at 31 December 2018 the maximum single entity share of the amount exposed to credit risk arising from these transactions amounted to 22%, or PLN 121 million (as at 31 December 2017: 47%, or PLN 124 million).

In order to reduce cash flows and at the same time to limit credit risk, the Company carries out net settlements (based on framework agreements entered into with its customers) to the level of the positive balance of fair value measurement of transactions in derivatives with a given counterparty. Moreover, the resulting credit risk is continuously monitored by the review of the credit ratings and is limited by striving to diversify the portfolio while implementing hedging strategies.
Despite the concentration of credit risk associated with derivatives’ transactions, the Company has determined that, due to its cooperation only with renowned financial institutions, as well as continuous monitoring of their ratings, it is not materially exposed to credit risk as a result of transactions concluded with them.

The fair value of open derivatives of the Company and receivables due to unsettled derivatives are presented by the main counterparties in the table below:

Note 7.5.2.3 Credit risk related to trade receivables

For many years, the Company has been cooperating with a large number of customers, which affects the geographical diversification of trade receivables. The majority of sales go to EU countries.

The following table presents a change in trade receivables measured at amortised cost.

The following table presents a change in the estimation of expected credit losses on trade receivables measured at amortised cost.

The Company limits its exposure to credit risk related to trade receivables by evaluating and monitoring the financial condition of its customers, setting credit limits and requiring collateral. An inseparable element of the credit risk management process performed by the Company is the continuous monitoring of receivables and the internal reporting system.

Buyer’s credit is only provided to proven, long-term customers, while sales of products to new customers are mostly based on prepayments or trade financing instruments which wholly transfer the credit risk to financial institutions.

The Company makes use of the following forms of collateral:

• registered pledges, bank guarantees, promissory notes, notarial enforcement declarations, corporate guarantees, cessation of receivables, mortgages and documentary collection;
• ownership rights to merchandise to be transferred to the buyer only after payment is received;
•  a receivables insurance contract, which covers receivables from entities with buyer’s credit which have not provided strong collateral or have provided collateral which does not cover the total amount of the receivables

Taking into account the aforementioned forms of collateral and the credit limits received from the insurance company, as at 31 December 2018 the Company had secured 75% of its trade receivables (as at 31 December 2017: 95%).

The total value of the Company’s net trade receivables as at 31 December 2018, without the fair value of collaterals, to the value of which the Company may be exposed to credit risk, amounts to PLN 310 million (as at 31 December 2017:
PLN 1 034 million).

The concentration of credit risk in the Company is related to the terms of payment allowed to key clients. Consequently, as at 31 December 2018 the balance of receivables from the Company’s 7 largest clients, in terms of trade receivables at the end of the reporting period, represented 50% of the balance of trade receivables (as at 31 December 2017: 84%).

Despite the concentration of this type of risk, the Company believes that due to the available historical data and the many years of experience in cooperating with its clients, as well as to securities used, the level of credit risk is low.

Note 7.5.2.4 Credit risk related to other financial assets

Major items in other financial assets are:

• cash accumulated in the special purpose funds: Mine Closure Fund and Tailings Storage Facility Restoration Fund in the amount of PLN 314 million (credit risk is described in Note 7.5.2.1),
• net receivables due to cash pooling in the amount of PLN 247 million. Credit risk in this regard is continuously monitored through the on-going review of the financial standing and assets of the companies participating in the cash pooling.

Note 7.5.2.5 Credit risk related to loans granted

Loans granted measured at amortised cost

The Company estimates expected credit losses related to loans granted measured at amortised cost in accordance with the general approach.

The following table presents the change in the period in the gross value of loans granted measured at amortised cost.

The following table presents the change in the period in the value of allowance for impairment of loans granted measured at amortised cost.

The basis for accruing interest on loans measured at amortised cost is the gross value less any allowance for impairment.

In 2018 no loans were classified to Stage 3 of the measurement.

Loans, due to impairment recognised at the moment of initial recognition, were classified as POCI for the purpose of calculating expected credit losses.

The loss due to initial recognition of POCI-type loans granted recognised in the statement of profit or loss for 2018 amounted to PLN 763 million. However, as a result of impairment testing, there was a recognition of gains due to the reversal of allowances for impairment due to initial recognition of POCI loans for 2018 in the amount of PLN 85 million.

Loans granted measured at fair value

The carrying amount of loans measured at fair value as at 31 December 2018 amounted to PLN 1 724 million.
As at 1 January 2018, the carrying amount was PLN 1 255 million.

The following table presents changes in the carrying amount of loans granted measured at fair value during the period.