Annual Report and Accounts 2006
Notes to the Financial Statements
28. Financial instruments
Treasury risk management policies
The Group is exposed to market risks arising from its international business. Derivative financial instruments are utilised by the Group to lower funding costs, to diversify sources of funding, to alter interest rate exposures arising from mismatches between assets and liabilities or to achieve greater certainty of future costs. These instruments are entered in to in accordance with policies approved by the Board of Directors and are subject to regular review and audit. Other than expressly stated, the policies set out below also apply to prior years.
Substantially all derivative financial instruments that are entered into hedge specifically identified actual or anticipated transactions; movements in their fair value are highly negatively correlated with movements in the fair value of the transactions being hedged. The terms of the hedging instruments are designed to match the terms of the hedged transactions. Such anticipated transactions are all in the normal course of business and the Group is of the opinion that it is highly probable that they will occur. However, some transactions do not always meet the stringent conditions prescribed by IAS 39 to obtain hedge accounting.
(a) Liquidity risk
The Group seeks to achieve a balance between certainty of funding, even at difficult times for the markets or the Group, and a flexible, cost-effective borrowings structure. Consequently the policy seeks to ensure that all projected net borrowing needs are covered by committed facilities.
The objective for debt maturities is to ensure that the amount of debt maturing in any one year is not beyond the Group's means to repay and refinance. To this end the policy provides that at least 75% of year end net debt should have a maturity of one year or more and at least 50%, 3 years or more. Committed but undrawn facilities are taken into account for this test.
(b) Interest rate risk
The Group has an exposure to interest rate fluctuations on its borrowings and manages these by the use of interest rate swaps, cross currency interest rate swaps, forward rate agreements and interest rate caps. The objectives for the mix between fixed and floating rate borrowings are set to reduce the impact of an upward change in interest rates while enabling benefits to be enjoyed if interest rates fall.
The policy sets minimum and maximum levels of the total of net debt and preferred securities permitted to be at fixed or capped rates in various time bands, ranging from 50% to 100% for the period up to six months, to 0% to 30% when over five years. These percentages are measured with reference to the current annual average level of debt. 75% of net debt was at fixed rates of interest at year end (2005: 84%; 2004: 85%).
(c) Currency risk
The Group operates internationally giving rise to exposure from changes in foreign exchange rates, particularly the US dollar.
The Group does not hedge translation exposure and earnings because any benefit obtained from such hedging can only be temporary.
The Group seeks to relate the structure of borrowings to the trading cash flows that service them. The Group's policy is to maintain broadly similar fixed charge cover ratios for each currency bloc and to ensure that the ratio for any currency bloc does not fall below two times in any calendar year. This is achieved by raising funds in different currencies and through the use of hedging instruments such as swaps.
The Group also has transactional currency exposures arising from its international trade. The Group's policy is to take forward cover for all forecasted receipts and payments for as far ahead as the pricing structures are committed, subject to a minimum of three months' cover. The Group makes use of the forward foreign exchange markets to hedge its exposures.
While there are exchange control restrictions which affect the ability of certain of the Group's subsidiaries to transfer funds to the Group, the operations affected by such restrictions are not material to the Group as a whole and the Group does not believe such restrictions have had or will have any material adverse impact on the Group as a whole or the ability of the Group to meet its cash flow requirements.
(d) Commodity risk
In respect of commodities the Group enters into derivative contracts for cocoa, sugar, aluminium and other commodities in order to provide a stable cost base for marketing finished products. The use of commodity derivative contracts enables the Group to obtain the benefit of guaranteed contract performance on firm priced contracts offered by the banks, the exchanges and their clearing houses.
(e) Credit risk
The Group is exposed to credit related losses in the event of non-performance by counterparties to financial instruments, but it does not expect any counterparties to fail to meet their obligations given the Group's policy of selecting only counterparties with high credit ratings. The exposure to credit loss of liquid assets is equivalent to the carrying value on the balance sheet. The maximum credit exposure of interest rate and foreign exchange derivative contracts is represented by the fair value of contracts with a positive fair value at the reporting date.
Counterparties to financial instruments are limited to financial institutions with high credit ratings assigned by international credit rating agencies. The Group has ISDA Master Agreements with most of its counterparties to financial derivatives, which permits net settlement of assets and liabilities in certain circumstances, thereby reducing the Group's credit exposure to individual counterparties. The Group has policies that limit the amount of credit exposure to any single financial institution. There were no significant concentrations of credit exposure at the year-end.
At the year-end, the Group had US$59 million notional value worth of currency swaps with a financial institution with a credit quality lower than that permitted under Group Policy. $3.6 million cash collateral has been obtained from the counterparty as security to mitigate against the higher credit risk. The book value of the cash collateral is equal to its fair value. There were no significant concentrations of credit exposure at year-end.
Concentrations of credit risk with respect to trade receivables are limited due to the Group's customer base being large and unrelated. Management therefore believe there is no further credit risk provision required in excess of normal provision for doubtful receivables.
The Group is exposed to £3,520 million in credit exposure on financial guarantees issued in respect of Group corporate borrowings and certain subsidiary undertakings which represents the Group's maximum credit exposure arising from guarantees. See Note 34 on Commitments and Contingencies for further details.
(f) Foreign currency derivatives
Terms and conditions of financial instruments
The Group enters into forward foreign currency contracts to eliminate the currency exposures that arise on transactions denominated in foreign currencies. At 31 December 2006, the Group held contracts to exchange sterling for the following foreign currencies; the table represents the contracted sterling cashflows at the year end.
Foreign exchange trades against £
| 2006 Current |
2006 Non-current |
|||||||
| $ £m |
€ £m |
AUD £m |
DKK £m |
NZD £m |
Other £m |
€ £m |
Other £m |
|
|---|---|---|---|---|---|---|---|---|
| Purchase | 74 | 438 | 43 | 63 | 93 | 136 | – | – |
| Sale | (419) | (64) | (111) | (12) | – | (44) | – | – |
| Total £ equivalent notional | (345) | 374 | (68) | 51 | 93 | 92 | – | – |
At 31 December 2006 the Group also held contracts to exchange US dollars against the following foreign currencies at future dates. The table below shows contracted US dollar cash flows against the presented foreign currencies translated into sterling at the year end spot rate.
Foreign exchange trades against $
| 2006 Current |
2006 Non-current |
|||||||
|---|---|---|---|---|---|---|---|---|
| CAD £m |
AUD £m |
€ £m |
DKK £m |
NZD £m |
Other £m |
€ £m |
Other £m |
|
| Purchase | 47 | 10 | 50 | – | 2 | 10 | – | – |
| Sale | (78) | (24) | (14) | (1) | (3) | (20) | – | (4) |
| Total £ equivalent notional | (31) | (14) | 36 | (1) | (1) | (10) | – | (4) |
At 31 December 2006, the Group had approximately £55 million forward transactions relating to currencies other than US dollars or sterling all of which mature in 2007. The majority of forward foreign exchange contracts mature within 12 months. The maximum maturity of forward foreign exchange transactions is March 2008.
Foreign exchange trades against £
| 2005 Current |
2005 Non-current |
|||||||
| $ £m |
€ £m |
AUD £m |
DKK £m |
NZD £m |
Other £m |
€ £m |
Other £m |
|
|---|---|---|---|---|---|---|---|---|
| Purchase | 289 | 702 | – | 29 | – | 13 | – | – |
| Sale | (109) | (543) | (240) | (98) | – | – | – | (6) |
| Total £ equivalent notional | 180 | 159 | (240) | (69) | – | 13 | – | (6) |
Foreign exchange trades against $
| 2005 Current |
2005 Non-current |
|||||||
| CAD £m |
AUD £m |
€ £m |
Other £m |
CAD £m |
AUD £m |
€ £m |
Other £m |
|
|---|---|---|---|---|---|---|---|---|
| Purchase | 109 | 18 | 32 | 67 | – | 4 | – | – |
| Sale | (159) | (47) | (11) | (24) | – | (18) | – | – |
| Total £ equivalent notional | (50) | (29) | 21 | 43 | – | (14) | – | – |
At 1 January 2006, the Group had approximately £175 million forward transactions relating to currencies other than US dollars or sterling maturing in 2006 and £2 million maturing in 2007
The majority of the forward foreign exchange contracts mature within 12 months. The maximum maturity of forward exchange contracts is June 2007.
Foreign exchange trades against £
| 2004 Current |
2004 Non-current |
|||||||
| $ £m |
€ £m |
MXN £m |
Other £m |
$ £m |
€ £m |
MXN £m |
Other £m |
|
|---|---|---|---|---|---|---|---|---|
| Purchase | 111 | 518 | – | 3 | – | 10 | – | – |
| Sale | (39) | (188) | (7) | (76) | (4) | – | – | (8) |
| Total £ equivalent notional | 72 | 330 | (7) | (73) | (4) | 10 | – | (8) |
Foreign exchange trades against $
| 2004 Current |
2004 Non-current |
|||||||
| CAD £m |
AUD £m |
€ £m |
Other £m |
CAD £m |
AUD £m |
€ £m |
Other £m |
|
|---|---|---|---|---|---|---|---|---|
| Purchase | 88 | 25 | 5 | 21 | – | – | – | 10 |
| Sale | (83) | (54) | (11) | (26) | (20) | (10) | – | (4) |
| Total £ equivalent notional | 5 | (29) | (6) | (5) | (20) | (10) | – | 6 |
At 2 January 2005, the Group had approximately £184 million forward transactions relating to currencies other than US dollars or sterling maturing in 2005 and £7 million maturing in 2006.
(g) Interest rate derivatives
The Group uses a combination of short-term and long-term cross currency and interest rate swaps to manage the currency and interest rate profile of its borrowings. Details of the fixed rate element of the swap portfolio are shown in the table below:
| 2006 | ||||||||
| Notional principal £m |
Weighted average interest rate % |
Maturing in less than one year £m |
Maturing
in the second year £m |
Maturing in the third year £m |
Maturing in the fourth year £m |
Maturing in the fifth year £m |
After five years £m |
|
|---|---|---|---|---|---|---|---|---|
| Currency/instrument | ||||||||
| £ | ||||||||
| Receive fixed | 100 | 4.88 | – | – | – | 100 | – | – |
| Euro | ||||||||
| Receive fixed | 20 | 3.86 | 20 | – | – | – | – | – |
| Pay fixed | 135 | 3.72 | – | 68 | 67 | – | – | – |
| $ | ||||||||
| Receive fixed | 919 | 2.96 | 510 | 409 | – | – | – | – |
| Pay fixed | 1,276 | 3.62 | 715 | 561 | – | – | – | – |
| Other | ||||||||
| Receive fixed | 66 | 2.89 | 34 | 32 | – | – | – | – |
| 2005 | ||||||||
| Notional principal £m |
Weighted average interest rate % |
Maturing in less than one year £m |
Maturing
in the second year £m |
Maturing in the third year £m |
Maturing in the fourth year £m |
Maturing in the fifth year £m |
After five years £m |
|
|---|---|---|---|---|---|---|---|---|
| Currency/instrument | ||||||||
| £ | ||||||||
| Receive fixed | 250 | 5.40 | 150 | – | – | – | 100 | – |
| Euro | ||||||||
| Receive fixed | 21 | 3.86 | – | 21 | – | – | – | – |
| Pay fixed | 137 | 3.72 | – | – | 137 | – | – | – |
| $ | ||||||||
| Receive fixed | 1,046 | 2.96 | – | 581 | 465 | – | – | – |
| Pay fixed | 1,454 | 3.62 | – | 814 | 640 | – | – | – |
| Other | – | – | – | |||||
| Receive fixed | 155 | 2.46 | 58 | 37 | 60 | – | – | – |
| Pay fixed | 122 | 5.31 | 122 | – | – | – | – | – |
| Forward start pay fixed | 64 | 5.85 | – | 64 | – | – | – | – |
On swaps where fixed rates of interest are payable, the Group receives interest at floating rates of 3 months or 6 month LIBOR rates (or local equivalent). On swaps where fixed rates of interest are received, the Group pays interest at floating rates set at 3 month or 6 month LIBOR plus an average margin of 0.50%.
The differential to be paid or received on the current leg of swap agreements is accrued as interest rates change and is recognised within finance costs in the periods that they arise over the lives of the respective agreements. The remaining cash flows to maturity of each swap are discounted at current market rates to determine the fair value of swap agreements at yearend.
(h) Commodities
In respect of commodities the Group enters into derivative contracts for cocoa, sugar, aluminium and other commodities in order to provide a stable cost base for marketing finished products. The use of commodity derivative contracts enables the Group to obtain the benefit of guaranteed contract performance on firm priced contracts offered by banks, the exchanges and their clearing houses.
The Group held the following commodity derivative contracts at 31 December 2006:
| 2006 Fair value £m |
2005 Fair value £m |
2004 Fair value £m |
|
|---|---|---|---|
| Commodities (assets) | 3 | 13 | 5 |
| Commodities (liabilities) | (5) | (1) | (7) |
| Total £ equivalent notional | (2) | 12 | (2) |
Commodity derivative contracts were held in sterling and US dollars. The equivalent notional value of commodities held at the year end increased from £135 million in 2005 to £160 million in 2006, the majority of which matures within one year.
The commodities derivative contracts held by the Group at the year end expose the Group to adverse movements in cash flow and gains or losses due to the market risk arising from changes in prices for sugar, cocoa, aluminium and other commodities traded on the commodities exchanges. Applying a reasonable adverse movement in commodity prices to the Group's net commodity positions held at the year end would result in a decrease in fair value of £7.0 million (2005: £6.8 million; 2004: £11.6 million). The price sensitivity applied in this case is estimated based on an absolute average of historical monthly changes in prices in the Group's commodities over a 2 year period. Stocks, priced forward contracts and estimated anticipated purchases are not included in the calculations of the sensitivity analysis. This method of analysis is used to assess and mitigate risk and should not be considered a projection of likely future events and losses. Actual results and market conditions in the future may be materially different from the projection in this note and changes in the instruments held and in the commodities markets in which the Group operates could cause losses to exceed the amounts projected.
(i) Embedded derivatives
The Group has reviewed all contracts for embedded derivatives that are required to be separately accounted for if they do not meet certain requirements set out in IAS 39. As at 31 December 2006, the fair value of embedded derivatives was an asset of £0.5 million (2005: £1.9 million). This relates to foreign exchange forward contracts embedded within certain procurement contracts with maturities of between one and two years. Amounts recorded in the income statement are included within those disclosed in Note 10 to the financial statements.
(j) Fair values and sensitivity analysis
Fair values of non-derivative financial assets and liabilities:
The fair values for public debt are based on quoted market prices. For cash and cash equivalents, trade and other receivables, trade and other payables and short-term loans and receivables with a maturity of less than one year the book values approximate the fair value because of their short-term nature. For non-public long-term loans and receivables, fair values are estimated by discounting future contractual cash flows to net present values using at the current market interest rates available to the Group for similar financial instruments as at year end. The table below contains fair values of debt instruments based on clean prices excluding accrued interest.
| 2006 | 2005 | |||
| Book value £m |
Fair value £m |
Book value £m |
Fair value £m |
|
|---|---|---|---|---|
| Floating rate debt | ||||
| EUR floating rate notes due 2007 | 404 | 405 | 410 | 413 |
| Commercial paper | 603 | 603 | 392 | 392 |
| Bank Loans in foreign currencies | 213 | 213 | 189 | 184 |
| Bank overdrafts | 84 | 84 | 55 | 55 |
| Other notes maturing 2006-2009 | 56 | 56 | 120 | 122 |
| Obligations under finance leases | 55 | 52 | 63 | 64 |
| Other loans | 2 | 2 | 3 | 3 |
| 1,417 | 1,415 | 1,232 | 1,233 | |
| Fixed rate debt | ||||
| 5.75% USD notes due 2006 | – | – | 291 | 292 |
| 5.75% GBP notes due 2006 | – | – | 250 | 252 |
| 5% USD notes due 2007 | 153 | 153 | 175 | 174 |
| 4.9% CAD notes due 2008 | 142 | 143 | 162 | 164 |
| 3.875% USD notes due 2008 | 509 | 498 | 581 | 565 |
| 4.25% EUR notes due 2009 | 403 | 403 | 410 | 424 |
| 4.875% GBP notes due 2010 | 77 | 75 | 400 | 399 |
| 5.125% USD notes due 2013 | 508 | 496 | 581 | 577 |
| Other notes maturing 2006-2009 | 95 | 94 | 197 | 197 |
| 1,887 | 1,862 | 3,047 | 3,044 | |
| Total gross borrowings | 3,304 | 3,277 | 4,279 | 4,277 |
For currency and interest rate derivatives, fair values are calculated using standard market calculation conventions with reference to the relevant closing market spot rates, forward foreign exchange and interest rates. The fair values of derivative instruments are based on the estimated amount the Group would receive or pay if the transaction was terminated. Financial derivatives are recorded on the balance sheet at fair value with changes in fair value being recognised immediately in the income statement, except when the derivative has been designated as part of an effective cash flow hedge in which case up to all the gains and losses could be deferred into equity until the hedged transaction affects the income statement.
The table below presents the changes in fair value of the Group's financial instruments to hypothetical changes in market rates. The analysis below shows forward-looking projections of market risk assuming certain adverse market conditions occur. The sensitivity figures are calculated based on an upward parallel shift of 1% in yield curves and 10% weakening of sterling against other exchange rates. This is a method of analysis used to assess and mitigate risk and should not be considered a projection of likely future events and losses. Actual results and market conditions in the future may be materially different from those projected and changes in the instruments held and in the financial markets in which the Group operates could cause losses to exceed the amounts projected.
As at 31 December 2006
| Fair value change arising from | |||
| Fair value £m |
1% decrease in interest rates favourable/ (unfavourable) £m |
10% weakening in £ against other currencies favourable/ (unfavourable) £m |
|
|---|---|---|---|
| Derivatives | |||
| Currency and interest rate swaps (assets) | 10 | (1) | 1 |
| Currency and interest rate swaps (liabilities) | – | – | – |
| Interest rate swaps (assets) | 15 | 10 | 2 |
| Interest rate swaps (liabilities) | (19) | (8) | (2) |
| Currency exchange contracts (assets) | 26 | – | 3 |
| Currency exchange contracts (liabilities) | (16) | – | (2) |
| Commodity contracts (assets) | 3 | – | – |
| Commodity contracts (liabilities) | (5) | – | (1) |
As at 1 January 2006
| Fair value change arising from | |||
| Fair value £m |
1% decrease in interest rates favourable/ (unfavourable) £m |
10% weakening in £ against other currencies favourable/ (unfavourable) £m |
|
|---|---|---|---|
| Derivatives | |||
| Currency and interest rate swaps (assets) | 12 | 2 | 1 |
| Currency and interest rate swaps (liabilities) | (1) | – | – |
| Interest rate swaps (assets) | 26 | 14 | 2 |
| Interest rate swaps (liabilities) | (35) | (20) | (3) |
| Currency exchange contracts (assets) | 22 | – | 4 |
| Currency exchange contracts (liabilities) | (24) | – | – |
| Commodity contracts (assets) | 13 | – | 1 |
| Commodity contracts (liabilities) | (1) | – | – |
Some commodities are cash settled on a daily basis. Fair value gains and losses relating to these commodity instruments are reflected in cash and cash equivalents on the balance sheet. At the year end there was £1.1 million worth of gains relating to cash settled commodities (2005: £6.3million).