Annual Report and Accounts 2006
Treasury risk management
We are exposed to market risks arising from our international business. Derivative financial instruments are utilised 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 into in accordance with policies approved by the Board of Directors and are subject to regular review and audit. Other than as expressly stated, the policies set out below apply to prior years as well as being forward looking.
Substantially all financial instruments economically 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 and the term of such instruments is not greater than the term of such transactions or any anticipated refinancing or extension of them. Such anticipated transactions are all in the normal course of business and we are of the opinion that it is highly probable that they will occur. However, such transactions do not always meet the stringent conditions prescribed by IAS 39 to obtain hedge accounting.
(i) Liquidity risk
We seek to achieve a balance between certainty of funding, even at difficult times for the markets or ourselves, 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 our 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%, three years or more. Committed but undrawn facilities are taken into account for this test.
(ii) Interest rate risk
We have an exposure to interest rate fluctuations on our borrowings and manage these by the use of interest rate swaps, cross currency interest rate swaps and forward rate agreements. 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 the year end (2005: 84%; 2004: 85%). Assuming no changes to the borrowings or hedges, we estimate that a rise of 1 percentage point in interest rates in all currencies in which we have borrowings would have affected 2006 profit before tax by 2% (2005: less than 1%; 2004: 2%).
(iii) Currency risk
We operate internationally giving rise to exposure from changes in foreign exchange rates, particularly the US dollar. We do not hedge translation exposure and earnings because any benefit obtained from such hedging can only be temporary.
We seek to relate the structure of borrowings to the trading cash flows that service them. Our 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.
We also have transactional currency exposures arising from our international trade. Our 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. We make use of the forward foreign exchange markets to hedge these exposures.
While there are exchange control restrictions which affect the ability of certain of our subsidiaries to transfer funds to the UK, the operations affected by such restrictions are not material to our business as a whole and we do not believe such restrictions have had or will have any material adverse impact on our business as a whole or our ability to meet our cash flow requirements.
(iv) Fair value analysis
The table below presents the changes in fair value of our financial instruments to hypothetical changes in market rates. The fair values are quoted market prices or, if not available, values estimated by discounting future cash flows to net present values.
The change in fair values for interest rate movements assumes an instantaneous 1% (100 basis points) decrease in interest rates of all currencies, from their levels at 31 December 2006, with all other variables remaining constant. The change in fair values for exchange rate movements assumes an instantaneous 10% weakening in sterling against all other currencies, from their levels at 31 December 2006, with all other variables remaining constant. Further information on fair values is set out in Note 28 to the financial statements.
The sensitivity analysis below shows forward-looking projections of market risk assuming certain adverse market conditions occur for all financial instruments except commodities. 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 we operate could cause losses to exceed the amounts projected.
As at 31 December 2006:
| Fair value changes arising from | |||
| Fair Value £m |
1% decrease in interest rates favourable/ (unfavourable) £m |
10% weakening in £ against other currencies favourable/ (unfavourable) £m |
|
|---|---|---|---|
| Cash-cash equivalents | 269 | – | 14 |
| Short-term investments | 126 | – | 11 |
| Borrowings | (3,277) | 55 | 304 |
| Currency and interest rate swaps | 10 | (1) | 1 |
| Interest rate swaps | (4) | 2 | – |
| Currency exchange contracts (including embedded derivatives) |
10 | – | 1 |
As at 1 January 2006:
| Fair value changes arising from | |||
| Fair Value £m |
1% decrease in interest rates favourable/ (unfavourable) £m |
10% weakening in £ against other currencies favourable/ (unfavourable) £m |
|
|---|---|---|---|
| Cash-cash equivalents | 332 | – | 19 |
| Short-term investments | 47 | – | 4 |
| Borrowings | (4,277) | (96) | (364) |
| Currency and interest rate swaps | 11 | 2 | 1 |
| Interest rate swaps | (9) | (6) | (1) |
| Currency exchange contracts (including embedded derivatives) |
(2) | – | 4 |
As at 2 January 2005:
| Fair value changes arising from | |||
| Fair Value £m |
1% decrease in interest rates favourable/ (unfavourable) £m |
10% weakening in £ against other currencies favourable/ (unfavourable) £m |
|
|---|---|---|---|
| Cash-cash equivalents | 201 | – | 17 |
| Short-term investments | 145 | – | 8 |
| Borrowings | (4,254) | (97) | (312) |
| Currency and interest rate swaps | (5) | 4 | 20 |
| Interest rate swaps | (25) | (28) | (2) |
| Currency exchange contracts | (10) | – | 32 |
| Quarterly Income Preferred Securities (see Note 30) |
(219) | (2) | (22) |
(v) 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 futures contracts at 31 December 2006:
| 2006 Fair value £m |
2005 Fair value £m |
2004 Fair value £m |
|
|---|---|---|---|
| Commodities (asset) | 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 commodity 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 two 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.
(vi) Credit risk
We are exposed to credit related losses in the event of non-performance by counterparties to financial instruments, but we do not expect any counterparties to fail to meet their obligations given our policy of selecting only counterparties with high credit ratings. The credit exposure of interest rate and foreign exchange derivative contracts is represented by the fair value of contracts with a net positive fair value at the reporting date.