7.3 Financial risk management and financial derivatives
Principles of financial risk management
The Group is exposed to risks from movements in exchange rates, interest rates and market prices that affect its assets and liabilities. Financial risk management within the Group aims at reducing the impact of these market risks through ongoing operational and financing activities. Selected derivative hedging instruments are used depending on the assessment of risk involved. The Group hedges only the risks that affect the Group’s cash flow. Derivatives are used exclusively as hedging instruments and not for trading or other speculative purposes. To reduce the credit risk, hedging transactions are generally only concluded with financial institutions whose credit rating is at least A.
The guidelines and principles of the Bekaert financial risk policy are defined by the Audit and Finance Committee and overseen by the Board of the Group. Group Treasury is responsible for implementing the financial risk policy. This encompasses defining appropriate policies and setting up effective control and reporting procedures. The Audit and Finance Committee is regularly kept informed as to the currency and interest-rate exposure.
Currency risk
The Group’s currency risk can be split into two categories: translational and transactional currency risk.
Translational currency risk
A translation risk arises when the financial data of foreign subsidiaries are converted into the Group’s presentation currency, the euro. The main currencies are Chinese renminbi (considering the growing weight of the activities in China), US dollar, Czech koruna, Brazilian real and Chilean peso. Since there is no impact on the cash flows, the Group does not hedge against such risk.
Transactional currency risk
The Group is exposed to transactional currency risks resulting from its investing, financing and operating activities.
Foreign currency risk in the area of investment results from the acquisition and disposal of investments in foreign companies. At the reporting date, the Group was not exposed to any significant risk from foreign currency transactions in the field of investments. As a consequence, no hedging transactions were outstanding at the reporting date.
Foreign currency risk in the financing area results from financial liabilities in foreign currencies. In line with its policy, Group Treasury hedges these risks. Cross-currency interest-rate swaps and forward exchange contracts are used to convert financial obligations denominated in foreign currencies into the entity’s functional currency. At the reporting date, the foreign currency liabilities for which currency risks were hedged consisted of Eurobonds and intercompany loans mainly in euro and US dollar. Due to the hedges, the Group was not exposed to any significant currency risk in the area of financing at the reporting date.
A transactional currency risk arising from intra group dividend payments has increased significantly in the past year. At balance sheet date, the undistributed retained earnings of all Chinese entities amounted to CNY 3.8 billion. After balance sheet date the Group entered into non-deliverable forward contracts (NDFs) with different financial institutions for a total of CNY 1.8 billion with expiry date in November 2010.
Foreign currency risk in the area of operating activities arises from commercial activities with sales and purchases in foreign currencies, as well as payments and receipts of royalties and dividends. The Group uses forward exchange contracts to hedge the forecasted cash inflows and outflows for the coming six months. Significant exposures and firm commitments beyond that time frame may also be covered. Due to the hedges outstanding at the reporting date, the Group was not exposed to any significant currency risk in the area of its operating activities.
Currency sensitivity analysis
Currency sensitivity in relation to the operating activities
The table below summarizes the Group’s net foreign currency positions of trade receivables and trade payables at the reporting date for the most important currency pairs. Positive amounts indicate that the Group has a net future cash inflow in the first currency. In the table, the ‘Total exposure’ column represents the position on the balance sheet, while the ‘Total derivatives’ column includes all financial derivatives hedging those balance sheet positions as well as forecasted transactions. The annualized volatility is based on the daily movement of the exchange rate of the reported year, with a 95% confidence interval.
If rates had weakened/strengthened by the above estimated possible changes with all other variables constant, the result for the period before taxes would have been € 2.1 million lower/higher (2008: € 3.5 million).
Currency sensitivity in relation to hedge accounting
Some derivatives are also part of effective cash flow hedges in relation to the Eurobond issued in 2005 to hedge the currency risk. Exchange rate fluctuations in the currencies involved (US dollar and euro) affect the hedging reserve in shareholders’ equity and the fair value of these hedging instruments. If the euro had weakened/strengthened by the above estimated possible changes, with all other variables constant, the hedging reserve in shareholders’ equity would have been € 0.5 million higher/lower (2008: € 0.5 million).
Interest-rate risk
The Group is exposed to interest-rate risk, mainly in the US dollar, Chinese renminbi and euro. To minimize the effects of interest-rate fluctuations in these regions, the Group manages the interest-rate risk for net debt denominated in the respective currencies of these countries separately. General guidelines are applied to cover interest-rate risk:
- The target average life of long-term debt is four years.
- The allocation of long-term debt between floating and fixed interest rates must remain within the defined limits approved by the Audit and Finance Committee.
Group Treasury uses interest-rate swaps and cross-currency interest-rate swaps to ensure that the floating and fixed portion of the long-term debt remains within the defined limits. The Group also purchases forward starting interest-rate options to convert fixed and floating-rate long-term debt to capped long-term debt. As such, the Group is protected against adverse fluctuations in interest rates while still having the ability to benefit from decreasing interest rates.
The following table summarizes the average interest rates at the balance sheet date.
Interest-rate sensitivity analysis
Interest-rate sensitivity of the financial debt
As disclosed in note 6.16, the total financial debt of the Group as of 31 December 2009 amounted to € 739.3 million (2008: € 745.9 million). Of the total debt, 24.5% (2008: 62.4%) was bearing a floating interest rate, 11.7% (2008: 14.5%) a capped interest rate and 63.8% (2008: 23.1%) a fixed interest rate.
On the basis of the annualized daily volatility of the 3-month Interbank Offered Rate in 2009 and 2008, the reasonable estimates of possible changes, with a 95% confidence interval, are set out in the table below for the main interest rates.
Applying the estimated possible increase in the interest rates to the floating and capped rated debt, with all other variables constant, the result for the period before tax would have been € 0.6 million lower (2008: € 4.9 million lower). Applying the estimated possible decrease in the interest rates to the floating and capped rated debt, with all other variables constant, the result for the period before tax would have been € 0.6 million higher (2008: € 4.9 million higher).
Interest-rate sensitivity in relation to hedge accounting
Changes in market interest rates in relation to derivatives that are part of effective cash flow hedges to hedge payment fluctuations resulting from interest movements affect the hedging reserve in shareholders’ equity and the fair value of these hedging instruments. Applying the estimated possible increases of the interest rates to these transactions, with all other variables constant, the hedging reserve in shareholders’ equity would have been € 2.3 million higher (2008: € 0.6 million). Applying the estimated possible decreases of the interest rates to these transactions, with all other variables constant, the hedging reserve in shareholders’ equity would have been € 3.0 million lower (2008: € 2.1 million).
Credit risk
The Group is exposed to credit risk from its operating activities and certain financing activities. In respect of its operating activities, the Group has a credit policy in place, which takes into account the risk profiles of the customers in terms of the market segment to which they belong. Based on activity platform, product sector and geographical area, a credit risk analysis is made of customers and a decision is taken regarding the covering of the credit risk. The exposure to credit risk is monitored on an ongoing basis and credit evaluations are made of all customers. In terms of the characteristics of some steel wire activities with a limited number of global customers, the concentration risk is closely monitored and, in combination with the existing credit policy, action is taken as and when needed. Based on this credit strategy, the credit risk exposure was 46.2% (2008: 44.1%) covered by credit insurance policies and by trade finance techniques as at 31 December 2009. In respect of financing activities, transactions are normally concluded with counterparties that have at least an A credit rating. There are also limits allocated to each counterparty which depend on their rating. Due to this approach, the Group considers the risk of counterparty default to be limited in both operating and financing activities.
Liquidity risk
Liquidity risk is the risk that the Group will be unable to meet its obligations as they come due because of an inability to liquidate assets or obtain adequate funding. To ensure liquidity and financial flexibility at all times, the Group, in addition to its available cash, has several uncommitted short-term credit lines at its disposal in the major currencies and in amounts considered adequate for current and near-future financial needs. These facilities are generally of the mixed type and may be utilized, for example, for advances, overdrafts, acceptances and discounting. The Group also has committed credit facilities at its disposal up to a maximum equivalent of € 125.0 million (2008: € 125.0 million) at floating interest rates with fixed margins. These credit facilities will mature in 2012 and 2013. At year-end, € 2.5 million was outstanding under these facilities (2008: € 43.0 million). In addition, the Group has a commercial paper and medium-term note program available for a maximum of € 123.9 million (2008: € 123.9 million). No commercial paper notes were outstanding as at 31 December 2009 (2008: € 34.7 million).
The total contractually agreed outflows of the Group’s financial liabilities (including interest payments and trade payables, without compensation for gross settled derivatives) as at 31 December 2009 are: € 516.7 million in 2010, € 103.1 million in 2011, € 524.6 million for 2012-2014 and
€ 200.3 million in 2015 and later.
The following table shows the Group’s contractually agreed (undiscounted) outflows in relation to financial liabilities. Only net interest payments and principal repayments are included.
All instruments held at the reporting date and for which payments had been contractually agreed are included. Forecasted data relating to future, new liabilities is not included. Amounts in foreign currencies have been translated at the closing rate at the reporting date. The variable interest payments arising from the financial instruments were calculated using the applicable forward interest rates.
Hedging
All financial derivatives the Group enters into, relate to an underlying transaction or forecasted exposure. In function of the expected impact on the income statement and if the stringent IAS 39 criteria are met, the Group decides on a case by case basis whether hedge accounting will be applied. The following sections describe the transactions whereby hedge accounting is applied and transactions which do not qualify for hedge accounting but constitute an economical hedge.
Hedge accounting
Depending on the nature of the hedged exposure, IAS 39 makes a distinction between fair value hedges, cash flow hedges and hedges of a net investment. Fair value hedges are hedges of the exposure to variability in the fair value of recognized assets and liabilities. Cash flow hedges are hedges of the exposure to variability in future cash flows related to recognized assets or liabilities, highly probable forecasted transactions or unrecognized firm commitments. Hedges of a net investment are hedges of the exposure to variability of the net investment in the assets of an entity with a different functional currency.
Fair value hedges
In 2005, Bekaert Corporation, a U.S. based entity, issued a fixed rated 100 million Eurobond. Simultaneously, the entity also entered into two
€ 50 million cross-currency interest-rate swap to convert half of the fixed euro payments into floating US dollar payments and the other half of the fixed euro payments into fixed US dollar payments. During 2005, the entity reduced its floating US dollar exposure from € 50 million to € 30.9 million.
The Group has designated the portion of € 30.9 million from the 2005 Eurobond as a hedged item in a fair value hedge (the remaining
€ 69.1 million is treated as a hedged item in a cash flow hedge – see next section). The changes in the fair values of the hedged items resulting from changes in the spot rate USD/EUR are offset against the changes in the value of the cross-currency interest-rate swaps. Credit risks are not addressed or covered by this hedging.
The Group has designated cross-currency interest-rate swaps with an aggregate notional amount of € 30.9 million (2008: € 130.9 million) as fair value hedges as at 31 December 2009, the fair value amounting to € 3.7 million (2008: € 41.1 million). The change in fair value of the hedging instruments during 2009 resulted in a loss of € 37.1 million (2008: € 4.8 million loss) and this was included in other financial income and expenses.
The remeasurement of the hedged items resulted in a gain of € 37.1 million (2008: € 4.7 million gain), and this was also included in other financial income and expenses.
Cash flow hedges
The currency risk and interest-rate risk resulting from the remaining € 69.1 million of the 2005 Eurobond (see previous section on fair value hedges) has been hedged using a cross-currency interest-rate swap for € 50 million and a combination of a cross-currency interest-rate swap and an interest-rate swap for € 19.1 million. These financial derivatives convert fixed euro payments into fixed US dollar payments. The Group has designated the related portion of the Eurobond as hedged item. The objective of the hedge is to eliminate the risk from payment fluctuations as a result of changes in the exchange and interest rates. Credit risks are not addressed or covered by this hedging.
As at 31 December 2009, the Group has designated cross-currency interest-rate swaps and interest-rate swaps with notional amounts totaling € 88.2 million (2008: € 102.4 million) as cash flow hedges, the fair value amounting to € 3.6 million (2008: € -4.5 million). During 2009, gains totaling € 8.2 million (2008: € 7.7 million losses) resulting from the change in fair values of cross-currency and interest-rate swaps were taken directly to equity (hedging reserve). These changes represent the effective portion of the hedge relationship. A total amount of € 2.4 million was transferred from equity (hedging reserve) to other financial income and expenses to offset the unrealized exchange losses (2008: gains of
€ 3.7 million) recognized on the remeasurement of the Eurobond at closing rate.
Economic hedging
The Group also uses financial instruments that represent an economic hedge but for which no hedge accounting is applied, either because the criteria to qualify for hedge accounting defined in
IAS 39 ‘Financial Instruments: Recognition and Measurement’ are not met or because the Group has deliberately chosen not to apply hedge accounting. These derivatives are treated as free-standing instruments held for trading.
- The Group uses cross-currency interest-rate swaps and forward exchange contracts to hedge the currency risk on intercompany loans involving two entities with different functional currencies. Until now, the Group has elected not to apply hedge accounting as defined in IAS 39 since nearly all cross-currency interest-rate swaps are floating-to-floating and, hence, the fair value gain or loss on the financial instruments is expected to offset the foreign-exchange result arising from the remeasurement of the intercompany loans. The Group has entered into cross-currency interest-rate swaps with notional amounts totaling € 95.6 million (2008: € 219.6 million), the fair value amounting to € -2.1 million (2008: € 0.2 million). The major currencies involved are US dollars, Canadian dollars and British pounds. Foreign-exchange contracts represented a notional amount of € 47.2 million (2008: € 56.4 million) with a fair value of € -0.3 million
(2008: € 0.6 million). During 2009, a loss of € 3.2 million (2008: loss of € 3.1 million) resulting from changes in the fair values of cross-currency interest-rate swaps and forward exchange contracts was recognized under other financial income and expenses. A gain of € 1.0 million (2008: gain of € 6.5 million) has been recognized under unrealized exchange results arising on the remeasurement of the intercompany loans at spot rate.
- To manage its interest-rate exposure, the Group uses interest-rate swaps, forward rate agreements and interest-rate options to convert its floating-rate debt to a fixed and/or capped rate debt. Except for an interest-rate swap for 25 million US dollars, none of these interest-rate derivatives were designated as hedges as defined in IAS 39. As at 31 December 2009, the interest-rate exposure of debt was hedged using interest-rate swaps for a total gross amount of € 320.1 million (2008: € 148.0 million). The Group also purchased additional interest-rate options which resulted at year-end in an outstanding notional amount totaling € 127.8 million
(2008: € 272.4 million). No forward rate agreements were outstanding at 31 December 2009 (2008: € 158.1 million). The fair value at year-end of the interest-rate swaps amounted to € 3.4 million (2008: € -4.7 million) and that of the interest-rate options to € 1.9 million
(2008: € 2.6 million). During 2009, a gain of € 1.1 million (2008: € 2.7 million loss) resulting from the changes in fair values was recognized under other financial income and expenses.
- Finally, the Group uses forward exchange contracts to limit its commercial foreign-exchange risk. Since the Group has not designated its forward exchange contracts as cash flow hedges, the fair value change is recorded immediately under other financial income and expenses. As at 31 December 2009, the notional amount of the forward exchange contracts relating to commercial transactions was
€ 58.6 million (2008: € 106.1 million). The fair value at year-end amounted to € -0.7 million (2008: € -0.5 million), with a loss of € 0.2 million (2008: € 1.2 million loss). An additional loss of € 1.2 million (2008: € 0.4 million gain) was incurred from unrealized exchange losses on receivables and payables. However, the forward exchange contracts also relate to forecasted commercial transactions, for which there is no offsetting position on the balance sheet.
The following table analyzes the notional amounts of the derivatives according to their maturity date:
The following table summarizes the fair values of the various derivatives carried. A distinction is made depending on whether these are part of a hedging relationship as set out in IAS 39 (fair value hedge or cash flow hedge).
The table below shows how the use of derivatives mitigated the impact of the underlying risks on the income statement:
Of the total income statement effect in 2009, € -2.6 million is recognized in other financial income and expenses and € -0.1 million, i.e. the depreciation relating to the discontinued hedge relationship, is recognized in interest expense.
Of the total income statement effect in 2008, € -0.2 million is recognized in other financial income and expenses and € -0.1 million, i.e. the depreciation relating to the discontinued hedge relationship, is recognized in interest expense.
Additional disclosures on financial instruments by class and category
The following tables list the different classes of financial assets and liabilities with their carrying amounts in the balance sheet and their respective fair value and analyzed by their measurement category in accordance with IAS 39, Financial Instruments: Recognition and Measurement, or IAS 17, Leases.
Cash and cash equivalents, short-term deposits, trade receivables, other receivables, loans and receivables primarily have short terms to maturity; hence, their carrying amounts at the reporting date approximate the fair values. Furthermore, the Group has no exposure to collateralized debt obligations (CDO’s). Trade payables also generally have short times to maturity and, hence, their carrying amounts also approximate their fair values.
The following categories and abbreviations are used in the table below:
Financial instruments by fair value measurement hierarchy
The fair value measurement of financial assets and financial liabilities can be characterized in one of the following ways:
- ‘Level 1’ fair value measurement: the fair values of financial assets and liabilities with standard terms and conditions and traded on active liquid markets are determined with reference to quoted market prices in active markets for identical assets and liabilities.
This mainly relates to available-for-sale financial assets such as the investment in Shougang Concord Century Holdings Ltd (cf. note 6.5 ‘Other non-current assets’).
- ‘Level 2’ fair value measurement: the fair values of other financial assets and financial liabilities are determined in accordance with generally accepted pricing models based on discounted cash flow analysis using prices from observable current market transactions and dealer quotes for similar instruments. This mainly relates to derivative financial instruments. Forward exchange contracts are measured using quoted forward exchange rates and yield curves derived from quoted interest rates matching the maturities of the contracts. Interest-rate swaps, forward rate agreements and interest-rate options are measured at the present value of future cash flows estimated and discounted using the applicable yield curves derived from quoted interest rates adjusted for the Group’s credit spread. The fair value measurement of cross-currency interest-rate swaps is based on discounted estimated cashflows using quoted forward exchange rates, quoted interest rates adjusted for the Group’s credit spread and applicable yield curves derived therefrom.
- ‘Level 3’ fair value measurement: the fair values of the remaining financial assets and financial liabilities are derived from valuation techniques which include inputs which are not based on observable market data. As at the balance sheet date, no ‘Level 3’ techniques were used to determine the fair value of any financial assets or financial liabilities.
The following table provides an analysis of financial instruments measured at fair value in the balance sheet, in accordance with the fair value measurement hierarchy described above:
There were no transfers between Level 1 and 2 in the period.
Capital risk management
The Group manages its capital to ensure that entities in the Group will be able to continue as a going concern while maximizing the return to shareholders through the optimization of the net debt and equity balance. The Group’s overall strategy remains unchanged from 2008. Actions are taken to increase the average tenor of the debt.
The capital structure of the Group consists of net debt, which includes the elements disclosed in note 6.16 ‘Interest-bearing debt’, and equity (both attributable to the Group and to minority interests).
Gearing ratio
The Group’s Audit and Finance Committee reviews the capital structure on a semi-annual basis. As part of this review, the committee considers the cost of capital and the risks associated with each class of capital. The Group has a target gearing ratio of 50% determined as the proportion of net debt to equity.
