Appendix 3: Derivative Disclosures in Annual Reports
Almost every company listed on exchange in any part of the world discloses details of its hedging policy, instruments, risks and valuations of their current outstanding derivatives in their annual report and financial results subject to regulations applicable.
In order to provide readers an overview of the hedging policy and the kind of instruments used by large global organizations, relevant extracts along with link to their complete annual report has been provided:
Infosys
Link: http://www.infosys.com/investors/reports-filings/annual-report/annual/Documents/Infosys-AR-11.pdf
Extracts: We use foreign exchange forward contracts and options to hedge our exposure to movements in foreign exchange rate. The use of these foreign exchange forward contracts and options reduces our risks/cost. We do not use foreign exchange forward contracts or options for trading or speculation purpose.
Tata Motors
Link: http://www.tatamotors.com/investors/annualreports-pdf/Annual-Report-2010-2011.pdf
Extracts: The company uses forward exchange contracts, principal only swaps, interest rate swaps, currency swaps and currency options to hedge its exposure in foreign currency and interest rates.
Tata Consultancy Services
Link: http://www.tcs.com/investors/Documents/Annual%20Reports/TCS_Annual_Report_2010-2011.PDF
Extracts: The group uses foreign currency forward contracts and currency options to hedge its risks associated with foreign currency fluctuations relating to certain firm commitments and forecasted transactions.
Aditya Birla Nuvo
Link: http://www.adityabirlanuvo.com/investors/downloads/Nuvo_Annual_Report_2010-11.pdf
Extracts: The company uses derivative financial instruments such as currency swap and interest rate swaps to hedge its risks associated with foreign currency fluctuations and interest rate. The company has a mixed basket of fixed and floating rate borrowings. It continuously monitors its interest rate exposure to have a proper mix of fixed and floating rate borrowings in order to mitigate interest rate risk. The company also uses interest rate swap in case of foreign currency borrowings having floating interest rates.
Microsoft
Link: http://www.microsoft.com/investor/reports/ar10/10k_dl_dow.html
Extracts: We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates and credit; to enhance investment returns and to facilitate portfolio diversification.
Foreign Currency: Certain forecasted transactions, assets and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound and Canadian dollar.
Interest Rate: Our fixed-income portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use ‘To Be Announced’ forward purchase commitments of mortgagebacked assets to gain exposure to agency and mortgage-backed securities.
IBM
Link: ftp://public.dhe.ibm.com/annualreport/2010/2010_ibm_annual.pdf
Extracts: The company operates in multiple functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity and commodity price changes and client credit risk. The company limits these risks by following established risk management policies and procedures, including the use of derivatives, and, where cost effective, financing with debt in the currencies in which assets are denominated. For interest rate exposures, derivatives are used to better align rate movements between the interest rates associated with the company’s lease and other financial assets and the interest rates associated with its financing debt. Derivatives are also used to manage the related cost of debt. For foreign currency exposures, derivatives are used to better manage the cash flow volatility arising from foreign exchange rate fluctuations.
In its hedging programmes, the company uses forward contracts, futures contracts, interest-rate swaps and cross-currency swaps, depending upon the underlying exposure. The company is not a party to leveraged derivative instruments.
The company issues debt in the global capital markets, principally to fund its financing lease and loan portfolio. Access to cost-effective financing can result in interest rate mismatches with the underlying assets. To manage these mismatches and to reduce overall interest cost, the company uses interest-rate swaps to convert specific fixed-rate debt issuances into variable-rate debt (i.e. fair value hedges) and to convert specific variable-rate debt issuances into fixed-rate debt (i.e. cash flow hedges).
The company is exposed to interest rate volatility on future debt issuances. To manage this risk, the company may use forward starting interest-rate swaps to lock in the rate on the interest payments related to the forecasted debt issuance.
A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the US dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose.
Volkswagen
Extracts: 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 United States. 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 aluminium, 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.
BMW
Link: http://annual-report.bmwgroup.com/2010/gb/files/pdf/en/BMW_Group_AR2010.pdf
Extracts: The sale of vehicles outside the European Currency Union gives rise to exchange risks, in particular in relation to the Chinese renminbi, the US dollar, the British pound and the Japanese yen. These four currencies accounted for over two-thirds of our total foreign currency exposure in 2010. Cash-flow-at-risk models and scenario analyses are used to measure exchange rate risks. These instruments also serve as part of the process of currency management for the purpose of taking business decisions. We manage currency risks both at a strategic and at an operating level. At a strategic level (medium- and long-term), foreign exchange risks are managed by ‘natural hedging’, in other words, by increasing the volume of purchases denominated in foreign currency or increasing the volume of local production. In this context, the completed expansion of the plant in Spartanburg, the United States, and the new factory in Shenyang, China (under construction), will help to reduce foreign exchange risks in two major sales markets. For operating purposes (short- and medium-term), currency risks are hedged on the financial markets. Hedging transactions are entered into only with financial partners that have a good credit standing. Counterparty risk management procedures are carried out continuously to monitor creditworthiness. The relevant procedures are set out in mandatory work instructions. Interest-rate risks are managed by raising refinancing funds with matching maturities and by employing derivative financial instruments. Interest-rate risks are measured and limited both at country and group level on the basis of a value-at-risk approach. Limits are measured and interest-rate risks assessed on the basis of the risk-bearing concept, combined with targets defined in conjunction with the benchmark approach. The risk return ratio is also measured regularly using simulated computations in conjunction with a present-value-based interest rate management system. Sensitivity analyses, which contain stress scenarios and show the potential impact of interest-rate changes on earnings, are also used as tools to manage interest-rate risks.
Prudential
Link: http://www.prudential.co.uk/prudential-plc/investors/financialreports/2010/
Extracts: In the UK business, equity exposure is incurred in the with-profits fund, and it includes a large inherited estate. The inherited estate itself is partially protected against falls in equity markets by a derivative hedging portfolio. In the United States, to protect the shareholders against the volatility introduced by embedded options, Jackson uses both a comprehensive hedging programme and reinsurance. Jackson makes use of the natural offsets that exist between the variable annuity guarantees and the fixed index annuity book, and then uses a combination of OTC options and futures to hedge the residual risk, allowing for significant market shocks and limiting the amount of capital at risk. Internal positions are generally netted before any external hedge positions are considered. Jackson manages fixed annuity interest rate exposure through a combination of interest rate swaps and interest rate options, to protect capital against rates rising quickly and through the contractual ability to reset crediting rates annually. Prudential principally operates in the United Kingdom, the United States, and in 13 countries in Asia. The geographical diversity of the group’s business means that prudential is inevitably subject to the risk of exchange rate fluctuations. The group does not generally seek to hedge foreign currency revenues, as these are substantially retained locally to support the growth of the group’s business and meet local regulatory and market requirements. However, in cases where a surplus arising in an overseas operation supports group capital or shareholders’ interest, this exposure is hedged if it is economically optimal to do so. Currency borrowings, swaps and other derivatives are used to manage exposures.
AIG (American Institutional Group)
Link: http://www.aigcorporate.com/investors/AIG_2010_Annual_Report.pdf
Extracts: AIGFP has continued to unwind its portfolios, including those associated with credit protection written through credit default swaps on super senior risk tranches of diversified pools of loans and debt securities. As a consequence of its wind-down strategy, AIGFP is entering into new derivative transactions only to hedge its current portfolio, reduce risk and hedge the currency, interest rate and other market risks associated with its affiliated businesses.
AIGFP attempts to minimize risk in benchmark interest rates, equities, commodities and foreign exchange. Market exposures in option-implied volatilities, correlations and basis risks are also minimized over time. AIGFP’s minimal reliance on market risk-driven revenue is reflected in its VaR. AIGFP’s VaR calculation is based on the interest rate, equity, commodity and foreign exchange risk arising from its portfolio. Credit-related factors, such as credit spreads or credit default, are not included in AIGFP’s VaR calculation. Because the market risk with respect to securities available for sale, at market, is substantially hedged, segregation of the financial instruments into trading and other than trading was not considered necessary. AIGFP operates under established market risk limits based upon this VaR calculation. In addition, AIGFP back-tests its VaR AIG uses derivatives and other financial instruments as part of its financial risk management programmes and as part of its investment operations. AIGFP had also transacted in derivatives as a dealer and had acted as an intermediary between the relevant AIG subsidiary and the counterparty. In a number of situations, AIG has replaced AIGFP with AIG markets for purposes of acting as an intermediary between the AIG subsidiary and the third-party counterparty as part of the wind-down of AIGFP’s portfolios. Derivatives are financial arrangements among two or more parties with returns linked to or ‘‘derived’’ from some underlying equity, debt, commodity, or other asset, liability, or foreign exchange rate or other index or the occurrence of a specified payment event. Derivative payments may be based on interest rates, exchange rates, prices of certain securities, commodities, or financial or commodity indices or other variables. Derivatives, with the exception of bifurcated embedded derivatives, are reflected on the consolidated balance sheet in unrealized gain on swaps, options and forward transactions, at fair value and unrealized loss on swaps, options and forward contracts, at fair value. A bifurcated embedded derivative is recorded at fair value whereas the corresponding host contract is recorded on an amortized cost basis. A bifurcated embedded derivative is presented with the host contract on the consolidated balance sheet. Futures and forward contracts are contracts that obligate the holder to sell or purchase foreign currencies, commodities or financial indices in which the seller/purchaser agrees to make/take delivery at a specified future date of a specified instrument, at a specified price or yield. Options are contracts that allow the holder of the option to purchase or sell the underlying commodity, currency or index at a specified price and within, or at, a specified period of time. As a writer of options, AIGFP generally receives an option premium and then manages the risk of any unfavourable change in the value of the underlying commodity, currency or index by entering into offsetting transactions with third-party market participants. Risks arise as a result of movements in current market prices from contracted prices, and the potential inability of the counterparties to meet their obligations under the contracts.
Unilever
Link: http://www.unilever.com/images/ir_7_Financial_statements_AR09_tcm13208078.pdf#search=%22hedging%22
Extracts: Derivatives are measured on the balance sheet at fair value and are used primarily to manage the risks of changes in exchange and interest rates. The group uses foreign exchange forward contracts, interest rate swap contracts and forward rate agreements to hedge these exposures. The group also uses commodity contracts to hedge some raw materials. Contracts that can be settled in cash are treated as financial instruments. The group does not use derivative financial instruments for speculative purposes.
Procter and Gamble
Link: http://annualreport.pg.com/annualreport2011/_files/pdf/PG_2011_AnnualReport.pdf
Extracts: As a multinational company with diverse product offerings, we are exposed to market risks, such as changes in interest rates, currency exchange rates and commodity prices. We choose to further manage volatility associated with the net exposures. We enter into various financial transactions which we account for using the applicable accounting guidance for derivative instruments and hedging activities
Vodafone
Link: http://www.vodafone.com/content/annualreport/annual_report10/downloads/vf_ar2010.pdf
Extracts: The group’s activities expose it to the financial risks of changes in foreign exchange rates and interest rates. The use of financial derivatives is governed by the group’s policies approved by the board of directors, which provide written principles on the use of financial derivatives consistent with the group’s risk management strategy. Changes in values of all derivatives of a financing nature are included within investment income and financing costs in the income statement. The group does not use derivative financial instruments for speculative purposes.
Apple
Link: http://fi les.shareholder.com/downloads/AAPL/1541275946x0xS1193125-11-282113/320193/filing.pdf
Extracts: The company has used derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavourable movements in foreign exchange rates over the limited time the hedges are in place.
Honda
Link: http://world.honda.com/investors/library/annual_report/2011/honda2011ar-all-e.pdf
Extracts: Although, it is impossible to hedge against all currency or interest rate risk, Honda uses derivatives financial instruments in order to reduce the substantial effects of currency fluctuations and interest rate exposure on our cash flow and financial condition. These instruments include foreign currency forward contract, currency swap agreement and currency option contract, as well as interest rate swap agreements. Honda has entered into and expects to continue to enter into, such hedging arrangements.
Toyota
Link: http://www.toyotauk.com/main/download/pdf/2011%20TMC%20Annual%20Report.pdf
Extracts: Toyota is affected by fluctuations in foreign currency exchange rates. In addition to the Japanese yen, Toyota is exposed to fluctuations in the value of the US dollar and the euro and, to a lesser extent, the Australian dollar, the Canadian dollar, the British pound and others. Toyota’s consolidated financial statements, which are presented in Japanese yen, are affected by foreign currency exchange fluctuations through both translation risk and transaction risk.
Translation risk is the risk that Toyota’s consolidated financial statements for a particular period or for a particular date will be affected by changes in the prevailing exchange rates of the currencies in those countries in which Toyota does business compared with the Japanese yen. Even though the fluctuations of currency exchange rates to the Japanese yen can be substantial, and, therefore, significantly impact comparisons with prior periods and among the various geographic markets, the translation risk is a reporting consideration and does not reflect Toyota’s underlying results of operations. Toyota does not hedge against translation risk. Transaction risk is the risk that the currency structure of Toyota’s costs and liabilities will deviate from the currency structure of sales proceeds and assets. Transaction risk relates primarily to sales proceeds from Toyota’s non-domestic operations from vehicles produced in Japan. Toyota believes that the location of its production facilities in different parts of the world has significantly reduced the level of transaction risk. As part of its globalization strategy, Toyota has continued to localize production by constructing production facilities in the major markets in which it sells its vehicles. In calendar 2009 and 2010, Toyota produced 64.5 per cent and 73.4 per cent of Toyota’s non-domestic sales outside Japan, respectively. In North America, 60.0 per cent and 72.6 per cent of vehicles sold in calendar 2009 and 2010, respectively, were produced locally. In Europe, 57.0 per cent and 59.0 per cent of vehicles sold in calendar 2009 and 2010, respectively, were produced locally. Localizing production enables Toyota to locally purchase many of the supplies and resources used in the production process, which allows for a better match of local currency revenues with local currency expenses. Toyota also enters into foreign currency transactions and other hedging instruments to address a portion of its transaction risk. This has reduced, but not eliminated, the effects of foreign currency exchange rate fluctuations, which in some years can be significant. See notes 20 and 21 to the consolidated financial statements for additional information. Generally, a weakening of the Japanese yen against other currencies has a positive effect on Toyota’s revenues, operating income and net income attributable to Toyota Motor Corporation. A strengthening of the Japanese yen against other currencies has the opposite effect. In fiscal 2010 and 2011, the Japanese yen was on average and at the end of the fiscal year it became stronger against the US dollar and the euro in comparison to the prior fiscal year. See further discussion in ‘Quantitative and Qualitative Disclosures about Market Risk—Market Risk Disclosures—Foreign Currency Exchange Rate Risk’. During fiscal 2010 and 2011, the average exchange rate of the Japanese yen strengthened against the major currencies including the US dollar and the euro compared with the average exchange rate of the prior fiscal year. The operating results excluding the impact of currency fluctuations described in ‘Results of Operations—Fiscal 2011 Compared with Fiscal 2010’ and ‘Results of Operations — Fiscal 2010 Compared with Fiscal 2009’ show results of net revenues obtained by applying the Japanese yen’s average exchange rate in the previous fiscal year to the local currency-denominated net revenues for fiscal 2010 and 2011, respectively, as if the value of the Japanese yen had remained constant for the comparable periods. Results excluding the impact of currency fluctuations year-on-year are not on the same basis as Toyota’s consolidated financial statements and do not conform with US GAAP. Furthermore, Toyota does not believe that these measures are a substitute for US GAAP measures. However, Toyota believes that such results excluding the impact of currency fluctuations year-on-year provide additional useful information to investors regarding the operating performance on a local currency basis.