Our business activities entail financial risks that may arise from changes in interest rates, exchange rates, commodity prices and fund prices. Management of these financial risks as well as liquidity risk is the responsibility of the central Group Treasury department. We limit these risks using non-derivative and derivative financial instruments. The Group Board of Management is informed of the current risk situation on a regular basis.
The Group hedges interest rate risk, where appropriate in combination with currency risk, and risks arising from fluctuations in the value of financial instruments by means of interest rate swaps, cross-currency swaps and other interest rate contracts with matching amounts and maturity dates. This also applies to financing arrangements within the Volkswagen Group.
Foreign currency risk is reduced primarily through natural hedging, i.e. by flexibly adapting our production capacity at our locations around the world, establishing new production facilities in the most important currency regions and also procuring a large percentage of components locally, currently for instance in India, Russia and the USA. We hedge the residual foreign currency risk using hedging instruments. These include currency forwards, currency options and cross-currency swaps. We use these transactions to limit the currency risk associated with forecasted cash flows from operating activities and intra-Group financing in currencies other than the respective functional currency. The currency forwards and currency options can have a term of up to six years. We thus hedge our principal foreign currency risks associated with forecasted cash flows in the following currencies: US dollars, sterling, Czech koruna, Swedish krona, Russian rubles, Australian dollars, Polish zloty, Swiss francs, Mexican pesos and Japanese yen – mostly against the euro. The purchasing of raw materials gives rise to risks relating to availability and price trends. We limit these risks mainly by entering into forward transactions and swaps. We have used appropriate contracts to hedge some of our requirements for commodities such as aluminum, copper, lead, platinum, rhodium, palladium and coal over a period of up to eight years. Similar transactions have been entered into for the purpose of supplementing and improving allocations of CO2 emission certificates.
We ensure that the Company is solvent at all times by providing sufficient liquidity reserves, access to confirmed credit lines and by our tried-and-tested money market and capital market programs. We cover the capital requirements of the growing financial services business mainly through borrowings at matching maturities raised in the national and international financial markets. Risk premiums, a component of refinancing costs that had risen sharply when the financial and economic crisis broke, almost dropped back to pre-crisis levels in 2010. Thanks to the broadly diversified structure of our refinancing sources, we were able to raise sufficient liquidity in the various markets throughout 2010.
By diversifying when we invest excess liquidity and by entering into financial instruments for hedging purposes, we ensure that the Volkswagen Group remains solvent at all times, even in the event of a default by individual counterparties.
Credit lines from banks are generally only ever used within the Group to cover short-term working capital requirements. Projects are financed by, among other things, loans provided at favorable interest rates by development banks such as the European Investment Bank and the European Bank for Reconstruction and Development (EBRD), or by national development banks such as KfW and Banco Nacional de Desenvolvimento Econômico e Social (BNDES). This extensive range of options means that the liquidity risk to the Volkswagen Group is extremely low.
In the notes in the chapter , we explain our hedging policy, the hedging rules and the default and liquidity risks, and quantify the hedging transactions mentioned. Additionally, we outline the market risk within the meaning of IFRS 7.
Risks arising from financial instruments
Channeling excess liquidity into investments gives rise to counterparty risk. Partial or complete failure by a counterparty to perform its obligation to pay interest and repay principal would have a negative impact on earnings and liquidity. We counter this risk through our counterparty risk management, which is described in more detail explained in the section entitled "". In addition to counterparty risk, the financial instruments held for hedging purposes hedge balance sheet risks, which we limit by applying hedge accounting.
A rating downgrade could adversely affect the terms attached to the Volkswagen Group’s borrowings. One important criterion in this context is Volkswagen AG’s interest in Dr. Ing. h.c. F. Porsche AG, which resulted in a high outflow of liquidity at the end of 2009. In addition, at the beginning of 2010, Volkswagen acquired an interest in the Suzuki Motor Corporation at a total cost of around €1.8 billion. In the first half of 2010, Volkswagen AG implemented a capital increase by issuing new preferred shares. At the same time, this transaction strengthened Volkswagen’s financial stability and flexibility and enabled the Group to maintain its existing credit rating. The acquisition of the automobile trading operations of Porsche Holding Gesellschaft m.b.H. (Porsche Holding Salzburg) in 2011 will result in a further significant outflow of liquidity in the near future. Due primarily to its current liquidity and the inflow of funds from the capital increase, the Company does not anticipate any liquidity risks.
Residual value risk in the financial services business
In the financial services business, we agree to buy back selected vehicles at a residual value that is fixed at inception of the contract. Residual values are set realistically so that we are able to leverage market opportunities. We evaluate the underlying lease contracts at regular intervals and take the necessary precautions if we identify any potential risks.
Management of the residual value risk is based on a defined feedback loop ensuring the full assessment, monitoring, management and communication of risks. This process design ensures not only professional management of residual risks but also that we systematically improve and enhance our handling of residual value risks.
As part of our risk management, we use residual value forecasts to regularly assess the appropriateness of the provisions for risks and the potential for residual value risk. In so doing, we compare the contractually agreed residual values with the fair values obtainable. These are determined from data from external service providers and our own marketing data. We do not take account of the upside in residual market values when making provisions for risks.