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Note 25 Financial risk management
and financial instruments


Our activities expose us to a variety of financial risks: market risk (including: currency risk, fair value interest rate risk and price risk), cash flow interest rate risk, credit risk and liquidity risk. These risks are inherent to the way we operate as a multinational with a large number of locally operating subsidiaries. Our overall risk management program seeks to identify, assess, and – if necessary – mitigate these financial risks in order to minimize potential adverse effects on our financial performance. Our risk mitigating activities include the use of derivative financial instruments to hedge certain risk exposures. The Board of Management is ultimately responsible for risk management. Day-to-day risk management activities are carried out by a central treasury department (Corporate Treasury) in line with clearly identified and formalized corporate policies and in line with the Treasury Statute. Corporate Treasury identifies, evaluates and hedges financial risks at a corporate level, and monitors compliance with the corporate policies approved by the Board of Management, except for commodity risks, which are subject to identification, evaluation and hedging at business unit level rather than at corporate level. We have a Treasury Committee in place that advises the CFO in respect of the financial policy and evaluates the scope of liquidity, interest, credit and currency risk management.

The businesses play an important role in the process of identifying financial risk factors. Within the boundaries set in the corporate policies, the subsidiaries execute the appropriate risk management activities. We have three treasury hubs, which provide treasury services on behalf of Corporate Treasury to subsidiaries in their region. These treasury hubs are located in Brazil (São Paulo), Singapore and the United States (Chicago) and are primarily responsible for local cash management and short-term financing.

The Treasury Statute, as a rule, does not allow for extensive treasury operations to be executed at subsidiary level directly with external parties. It is corporate policy that derivatives are entered into through Corporate Treasury as much as possible.

Corporate Treasury is responsible for reporting to the Board of Management on company-wide exposures to a number of financial risks. This includes information regarding liquidity, foreign exchange, interest rate and credit risk. In addition, Corporate Treasury is responsible for maintaining a robust set of internal controls over treasury operations. We use a well-known treasury management system to support our treasury activities.

Foreign exchange risk management

Trade and financing transactions
Our subsidiaries operate in a large number of countries, and as such have clients and suppliers in many countries. Many of these subsidiaries have clients and suppliers that are outside of their functional currency environment. This exposes us to a large number of different currencies, many exposures of which cancel out on a consolidated basis.

The purpose of our foreign currency hedging activities is to protect us from the risk that the eventual functional currency net cash flows resulting from trade or financing transactions are adversely affected by changes in exchange rates. It is our policy to fully hedge our transactional foreign exchange rate exposures from recognized assets and liabilities. In general, we do not apply hedge accounting to foreign exchange contracts. Occasionally, we apply cash flow hedge accounting if that is necessary to prevent a significant accounting mismatch as a result of hedging exposures not yet included in the balance sheet.

Corporate Treasury enters into derivative transactions with external parties and is bound by overnight limits per currency. Some subsidiaries hedge their foreign exchange risk directly with local counterparties in order to comply with local legislation.

In January 2008, we acquired ICI, which resulted in an integration process with regard to treasury operations. As a consequence, former ICI companies did not yet fully apply above-mentioned policy to hedge the transactional foreign exchange rate exposures throughout the year. It is our objective to realize this in 2009 by incorporating all former ICI units in the current treasury management system.

In general, forward exchange contracts that we enter into have a maturity of less than one year. When necessary, forward exchange contracts are rolled over at maturity. Currency derivatives are not used for speculative purposes. We have defined in our corporate policies that we only use plain vanilla type forward contracts for our transactional hedging.

Translation risk related to investments in foreign subsidiaries associates and joint ventures
We have subsidiaries with a functional currency other than the euro. Therefore our consolidated financial statements are exposed to translation risk related to equity, intercompany loans of a permanent nature and earnings of foreign subsidiaries and investment in associates and joint ventures. In principle, we do not use financial instruments to hedge this risk.

In the following cases, we apply net investment hedge accounting. We have forward contracts to sell $780 million and buy £405 million, maturing in December 2011. This contract hedges the foreign currency risk on $780 million of net investments in foreign operations held by a GBP subsidiary. Both the forward contract and the permanent loan are valued through equity. During 2008, this hedge was fully effective. Another case where we apply net investment hedge accounting refers to hedges of US dollar net investments in foreign operations which were hedged by US dollar bonds. Until December 1, 2008, the bonds amounted to $1 billion. As from December 1, 2008, the US dollar bonds amount to $500 million with maturity to December 2013. During 2008, this hedge was fully effective.

We hedged the £8.1 billion acquisition of ICI for an amount of £5.3 billion by means of forward contracts. In connection with the acquisition of ICI, we entered into an agreement with Henkel to sell part of ICI’s National Starch business for £2.7 billion. The sale of these parts to Henkel was finalized in April 2008, implying that we had a natural hedge for an amount of £2.7 billion. As the payment for ICI was in January and the sale to Henkel in April, we entered into pound sterling swaps amounting to £2.5 billion. On completion of the acquisition of ICI in January 2008, an additional swap was entered into for the remaining amount of £0.2 billion. We applied cash flow hedge accounting to the pound sterling forward contracts. The fair value changes with respect to the pound sterling forward contracts of £8.1 billion in the light of the ICI acquisition amounted to a cumulative deferred loss of €627 million (€590 million during 2007 and €37 million in 2008). An amount of €551 million was transferred to goodwill and €76 million was recycled to discontinued operations. In relation to this transaction, we recorded a profit of €10 million in other operating income/(expenses) in 2008 due to foreign currency changes between January 2, 2008 (date of acquisition) and maturity of the contracts at January 15, 2008.

The fair value changes with respect to the pound sterling forward contracts in light of the on-sale of certain businesses to Henkel amounted to a cumulative deferred gain of €288 million (€63 million in 2007 and €215 million in 2008). During 2008 the hedge was fully effective and hedge accounting was applied.

Finally, for an amount of £106 million, loan notes paid as consideration for ICI will remain outstanding until 2013. This exposure was hedged by means of forward contracts for an amount of £105 million. We apply cash flow hedge accounting to this hedge. The hedge was 100 percent effective.

Foreign currency transaction risk
The table below presents a breakdown of the notional amounts of outstanding foreign currency contracts for entities with other functional currencies than the euro.

Hedged notional amounts at year-end

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In € millions

Buy

Sell

Buy

Sell

 

 

2008

 

2007

 

 

 

 

 

US dollar

58

1,201

76

932

Pound sterling

747

97

11,500

3,403

Swedish krona

101

36

255

64

Other

138

951

182

156

 

 

 

 

 

Total

1,044

2,285

12,013

4,555

Sensitivity analysis
We perform foreign currency sensitivity analysis by applying an adjustment to the spot rates prevailing at year-end. This adjustment is based on observed changes in the exchange rate in the past and management expectation for possible future movements. We then apply the expected possible volatility to revalue all monetary assets and liabilities (including derivative financial instruments) in a currency other than the functional currency of the subsidiary in its balance sheet at year-end. For the purpose of this sensitivity analysis, the effect of discounting to the net present value at balance sheet date is not taken into account.

At December 31, 2008, if the euro had weakened/strengthened by 10 percent against the US dollar with all other variables held constant, post-tax profit for the year would have been €9 million(2007: € nil) lower/higher. At December 31, 2008, if the euro had weakened/strengthened by 10 percent against the pound sterling with all other variables held constant, post-tax profit for the year would have been €1 million (2007: € nil) higher/lower. The increased sensitivity to foreign currencies is mainly due to former ICI entities which do not het fully apply our hedge policies.

Price risk management

Commodity price risk management
We use commodities, gas and electricity in our production processes and we are particularly sensitive to energy price movements.

Our Specialty Chemicals companies in the US hedge the price risk on natural gas through buying natural gas futures on the New York Mercantile Exchange. At year-end, the notional amounts of these futures are 1.6 million dekatherms, spread over all 12 months of 2009 (2007: 0.5 million dekatherms, spread over the first thee months of 2008). The total fair value of these futures is €2 million negative at year-end (2007: € nil). No hedge accounting is applied to the changes of the fair value of these contracts.

To hedge the price risks related to energy supply in the Netherlands, we operate two power plants in joint ventures with Essent in Delfzijl and Hengelo of 520 MW and 80 MW respectively. A third plant of 20 MW is located in Rotterdam. These plants transform natural gas into steam and electricity. The steam is used in our production facilities and excess electricity is sold on the market. The price for natural gas in our purchase contracts is a fixed or floating price. In order to hedge the price risk of natural gas in these contracts, we have entered into option contracts for the underlying oil price. At year-end 2008, the notional amount of oil call options is 37,500 barrels per month until September 2009 and 12,500 barrels from October through December 2009 (2008: average monthly volume of 31,250 barrels of oil for the period of January through December 2008). We do not apply hedge accounting to the changes of the fair value of these contracts.

To hedge the price risk of electricity that is used for the Specialty Chemicals plants in Sweden and Finland, we entered into future contracts on the power exchange Nord Pool Spot, based on expected use of electricity over the period 2009 – 2013. We apply cash flow hedge accounting to these contracts in order to mitigate the accounting mismatch that would otherwise occur. The effective part of the fair value changes of these contracts amounted to a €25 million loss net of deferred taxes in equity (2007: €18 million deferred gain). In 2008, a loss of €2 million was recorded in cost of goods sold due to ineffectiveness (2007: €3 million loss). The amounts deferred in equity at year-end are expected to affect operational cost within the next three years.

We hedge our agricultural commodities for our specialty food and industrial starches businesses and purchased futures on the Chicago Board of Trade. We apply cash flow hedge accounting to these contracts and have operated an effective hedging program throughout 2008. The agricultural commodities and cash markets have experienced significant volatility during 2008. Price peaks were particularly seen around the middle of the year; which were mostly influenced by severe flooding in the Mid West region of the US. Our standard practice is to hedge a substantial portion of our 2008/09 crop and at year-end, this amounted to hedges of approximately €94 million. The deferred gain on January 1, 2008 was €2 million. During the year, we deferred a loss of €19 million in equity and recognized a gain of €6 million in inventories. At year-end 2008, we deferred a loss of €24 million.

Sensitivity analysis
We perform our commodity price risk sensitivity analysis by applying an adjustment to the forward rates prevailing at year-end. This adjustment is based on observed changes in commodity prices in the previous year and management expectations for possible future movements. We then apply the expected volatility to revalue all commodity-derivative financial instruments in the applicable commodity in its balance sheet at year-end. For the purpose of this sensitivity analysis, the change of the price of the commodity is not discounted to the net present value at balance sheet date.

On December 31, 2008, if a parallel adjustment of the price curve of natural gas by €17,000 per 9,500 dekatherm up/down as compared with the market prices prevailing at that date had occurred, with all other variables held constant, post-tax profit would have been €2 million (2007: € nil) higher/lower. This is due to the fair value changes of natural gas derivatives.

On December 31, 2008, if the price of oil had weakened/strengthened by €4 per barrel (10 percent) as compared with the market prices prevailing at that date, with all other variables held constant, post-tax profit would have been € nil higher/lower (2007: €3 million). This is due to the fair value changes of oil derivatives which are accounted for at fair value through profit or loss.

On December 31, 2008, if the forward price of electricity on the Nord Pool exchange had weakened/strengthened by €4 per MWh (10 percent) as compared with the market prices prevailing at that date, with all other variables held constant, equity would have been €9 million (2007: €28 million) higher/lower. This is due to the fair value changes of electricity futures which have been accounted for under cash flow hedge accounting.

On December 31, 2008, if the forward price of agricultural commodities had weakened/strengthened by 10 percent as compared with the market prices prevailing at that date, with all other variables held constant, equity would have been €2 million higher/lower. This is due to the fair value changes of futures which have been accounted for under cash flow hedge accounting.

Cash flow and fair value interest rate risk management

We are partly financed with debt in order to obtain optimal leverage. Fixed rate debt results in fair value interest rate risk. Floating rate debt results in cash flow interest rate risk. The fixed/floating rate of our outstanding bonds shifted from 78 percent fixed at year-end 2007 to 56 percent fixed at year-end 2008.

In the past, ICI had entered into a number of interest rate swap contracts. The company swapped a total of $500 million fixed rate liabilities with an interest rate of 4.375 percent with a three-month floating rate US dollar Libor plus 0.877 percent related liabilities maturing in 2008. Furthermore, we swapped a total of $500 million fixed rate liabilities with an interest rate of 5.625 percent with a three-month floating rate US dollar Libor plus an average of 1.1056 percent liabilities maturing in 2013. We have classified these interest rate swaps as fair value hedges and record them at fair value.

We apply fair value hedge accounting to the above-mentioned interest rate swaps and fixed rate bonds. During 2008, an amount of €50 million has been accounted for in the statement of income for fair value changes of the interest rate swaps and an amount of €50 million has been accounted for in the statement of income as an adjustment to the carrying amount of the hedged bond for fair value changes attributable to the hedged risk. During 2008, these hedge relationships were fully effective.

The combined effective interest rate (excluding hedge results) was 5.24 percent at year-end 2008 for the total group. Including hedge result (by interest rate swaps), the combined effective interest rate was 5.13 percent for 2008.

Sensitivity analysis
At December 31, 2008, if EURIBOR interest rates had been 100 basis points higher/lower with all other variables held constant, post-tax profit for the year would have been €6 million lower/higher (2007: €8 million lower/higher).

Due to the acquisition of ICI, we are substantially more sensitive to the development of US and GBP Libor. At December 31, 2008, if US Libor interest rates had been 100 basis points higher/lower, with all other variables held constant, post-tax profit for the year would have been €4 million lower/higher (2007: € nil).

At December 31, 2008, if GBP Libor interest rates had been 100 basis points higher/lower, with all other variables held constant, post-tax profit for the year would have been €2 million higher/lower (2007: € nil).

Credit risk management

Credit risk arises from financial assets such as cash and cash equivalents, derivative financial instruments with a positive fair value, deposits with banks and financial institutions, and trade receivables.

We have a credit risk management policy in place to limit credit losses due to non-performance of financial counterparties and customers. We monitor our exposure to credit risk on an ongoing basis at various levels. We only deal with counterparties that have a sufficiently high credit rating. Generally, we do not require collateral in respect of financial assets.

Investments in cash and cash equivalents and transactions involving derivative financial instruments are entered into with counterparties that have sound credit ratings and good reputation. Derivative transactions are concluded mostly with parties with whom we have contractual netting agreements and ISDA agreements in place. In the Treasury Statute approved by the Board of Management, we have set limits per counterparty for the different types of financial instruments the company is allowed to use. Due to the credit crisis, both the acceptable rating and credit limit have been subject to revision and further restriction. We have no reason to expect non-performance by the counterparties for these financial instruments.

Due to our geographical spread and the diversity of our customers, we were not subject to any significant concentration of credit risks at balance sheet date. Generally, the maximum exposure to credit risk is represented by the carrying value of financial assets, including derivative financial instruments, in the balance sheet. For a total carrying amount of €315 million of long-term borrowings given, the maximum credit risk is best represented by an amount of €326 million being the repayment amount on redemption. At year-end 2008, the credit risk on consolidated level was €1.6 billion (2007: €12 billion). Our credit risk is well spread amongst both global and local counterparties. Our largest counterparty risk amount to €315 million end 2008. The credit risk from trade receivables is measured and analyzed at a local level, mainly by means of ageing analysis. See note 15.

Liquidity risk management

The primary objective of liquidity management is to provide for sufficient cash and cash equivalents at all times and any place in the world to enable us to meet our payment obligations. We aim for a well-spread maturity schedule of our long-term borrowings and a strong liquidity position.

We have a €1.5 billion multi-currency revolving credit facility expiring in 2013. At year-end 2008, € nil (2007: €350 million) of this facility had been drawn. We have a commercial paper program in the US, which at December 31, 2008, as at December 31, 2007, had a maximum of $1.0 billion and a euro commercial paper program, which at December 31, 2008, as at December 31, 2007, had a maximum of €1.5 billion. At December 31, 2008, €20 million of the commercial paper program was used (2007: €525 million). It must be stated that at the end of 2008, under current market conditions, this program was not accessible. The commercial paper program can only be used to the extent that the equivalent portion of the revolving credit facility is not used.

In Q4, 2008, bonds of an amount of €0.9 billion matured. We refinanced by means of a bond issue of €1 billion. This bond was placed in the market in December, maturing in five years, with an interest rate of 7.75 percent. Our balance sheet is strong, as the acquisition of ICI was financed by the proceeds from the Organon BioSciences divestment in 2007.

In May 2009, bonds of an amount of €1 billion will mature. We expect to pay off with available cash, and if necessary with our revolving credit facility or further refinancing in the capital markets.

The table below analyzes our cash outflows per maturity group based on the remaining period at balance sheet date to the contractual maturity date. The amounts disclosed in the table are the contractual undiscounted cash flows.

Maturity of liabilities and cash outflows

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In € millions

Less than
1 year

Between
1 and 5 years

Over 5 years

 

 

 

 

At December 31, 2007:

 

 

 

Borrowings

1,632

1,911

35

Interest on borrowings

144

141

Finance lease liabilities

3

7

1

Trade and other payables

1,261

 

 

 

 

Forward foreign exchange contracts (hedges):

 

 

- Outflow

15,380

706

- Inflow

(15,177)

(729)

 

 

 

 

Total

3,243

2,036

36

 

 

 

 

At December 31, 2008:

 

 

 

Borrowings

1,338

1,296

1,028

Interest on borrowings

138

490

78

Finance lease liabilities

4

17

Trade and other payables

2,985

 

 

 

 

Forward foreign exchange contracts (hedges):

 

 

- Outflow

2,147

653

- Inflow

(1,328)

(495)

 

 

 

 

Interest rate swaps:

 

 

 

- Outflow

16

57

- Inflow

(20)

(90)

 

 

 

 

Total

5,280

1,928

1,106

 

Capital risk management

Our objectives when managing capital are to safeguard our ability to satisfy our capital providers and to maintain a capital structure that optimizes our cost of capital. For this we maintain a conservative financial strategy, with the objective to remain a strong investment grade company as rated by the rating agencies Standard & Poor and Moody’s. The credit rating at year-end 2008 was A-/A3 with a negative outlook, similar to year-end 2007. The capital structure can be altered, among others, by adjusting the amount of dividends paid to shareholders, return capital to capital providers, or issue new debt or shares.

Consistent with others in the industry, we monitor capital on the basis of funds from operations in relation to our net borrowings level (FFO/NB-ratio). The FFO/NB-ratio for 2008 at year-end amounted to 0.29 (2007: 0.27). Funds from operations are based on net cash from operating activities, which is adjusted, among others, for the elimination of changes in working capital, additional payments for pensions and for the effects of the underfunding of pension and other post-retirement benefit obligations. Net borrowings is calculated as total of long- and short-term borrowings less cash and cash equivalents, adding an after-tax amount for the underfunding of pension and other post-retirement benefit obligations and lease commitments.

Fair value of financial instruments and IAS 39 categories

The carrying values and estimated fair values of financial instruments are as follows:

Fair value per financial instruments category

 

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Carrying value per
IAS 39 category

 

 

In € millions

Carrying amount

Out of scope of IFRS 7

Loans and receivables/ other liabilities

At fair value through profit or loss

Total carrying value

Fair value

 

 

 

 

 

 

 

2007 year-end:

 

 

 

 

 

 

Other financial non-current assets

630

133

497

497

497

Trade and other receivables

2,139

167

1,959

13

1,972

1,972

Cash and cash equivalents

11,628

356

11,272

11,628

11,628

 

 

 

 

 

 

 

Total financial assets

14,397

300

2,812

11,285

14,097

14,097

 

 

 

 

 

 

 

Long-term borrowings

1,954

1,954

1,954

1,910

Short-term borrowings

1,635

1,635

1,635

1,634

Trade and other payables

1,998

737

1,051

210

1,261

1,261

 

 

 

 

 

 

 

Total financial liabilities

5,587

737

4,640

210

4,850

4,805

 

 

 

 

 

 

 

2008 year-end:

 

 

 

 

 

 

Other financial non-current assets

757

402

315

40

355

355

Trade and other receivables

2,924

240

2,655

29

2,684

2,684

Cash and cash equivalents

1,595

1,194

401

1,595

1,595

 

 

 

 

 

 

 

Total financial assets

5,276

642

4,164

470

4,634

4,634

 

 

 

 

 

 

 

Long-term borrowings

2,341

2,341

2,341

2,376

Short-term borrowings

1,338

1,338

1,338

1,286

Trade and other payables

2,985

1,188

1,584

213

1,797

1,797

 

 

 

 

 

 

 

Total financial liabilities

6,664

1,188

5,263

213

5,476

5,459

Loans and receivables and other liabilities are recognized at amortized cost, using the effective interest method. We estimated the fair value of our long-term borrowings based on the quoted market prices for the same or similar issues or on the current rates offered to us for debt with similar maturities.

The carrying amounts of cash and cash equivalents, receivables less allowance for impairment, short-term borrowings and other current liabilities approximate fair value due to the short maturity period of those instruments.

We have not applied the fair value option allowed under IFRS. In 2008, we did not have financial instruments which were held for trading. However, as from 2009, we will report certain energy purchasing contracts within this category. The only financial instruments accounted for at fair value through profit or loss are derivative financial instruments and the short-term investments included in cash. The fair value of foreign currency contracts, swap contracts, forward rate agreements, oil contracts and gas futures was determined by valuation techniques using market observable input (such as foreign currency interest rates based on Reuters) and by obtaining quotes from dealers and brokers.

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