The most significant risks from the regular GRC process and QRP result from volatile foreign exchange markets.
Strategies for hedging financial risks
In the course of our business activities, financial risks may arise from changes in interest rates, exchange rates, raw material prices, or share and fund prices. Management of these financial and liquidity risks is the central responsibility of the Group Treasury department, which reduces these risks using nonderivative and derivative financial instruments. The Board of Management is informed of the current risk situation at regular intervals.
We hedge 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 interest rate swaps and other interest rate contracts with generally matching amounts and maturities. This also applies to financing arrangements within the Volkswagen Group.
Foreign currency risk is reduced in particular 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. We hedge the residual foreign currency risk using hedging instruments. These mainly comprise currency forwards and currency options. We use these transactions to limit the currency risk associated with forecasted cash flows from operating activities, intragroup financing and liquidity positions in currencies other than the respective functional currency, for example as a result of restrictions on capital movements. The currency forwards and currency options can have a term of up to ten years. We thus hedge our principal foreign currency risks, mostly against the euro and primarily in Australian dollars, Brazilian real, British pound sterling, Canadian dollars, Chinese renminbi, Czech koruna, Hong Kong dollars, Hungarian forints, Indian rupees, Japanese yen, Mexican pesos, Norwegian kroner, Polish zloty, Russian rubles, Singapore dollars, South African rand, South Korean won, Swedish kronor, Swiss francs, Taiwan dollars and US dollars.
The hedging of commodity prices entails risks relating to the availability of raw materials and price trends. We continuously analyze potential risks arising from changes in commodity and energy prices in the market so that immediate action can be taken whenever these arise. 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 aluminum, lead, coal and copper over a period of up to six years, in the case of nickel for up to nine years. The precious metals platinum, palladium and rhodium have shorter hedging periods, generally amounting to a maximum of up to three years. We have entered into similar transactions in order to supplement and improve allocations of CO2 emission certificates.
Note 34 of the consolidated financial statements explain our hedging policy, the hedging rules and the default and liquidity risks, and quantify the hedging transactions mentioned. Additionally, we disclose information on market risk within the meaning of IFRS 7.
Risks arising from financial instruments
Channeling excess liquidity into investments and entering into derivatives contracts gives rise to counterparty risk. Partial or complete failure by a counterparty to perform its obligation to pay interest and repay principal, for example, would have a negative impact on the Volkswagen Group’s earnings and liquidity. We counter this risk through our counterparty risk management, which we describe in more detail in the section entitled “Principles and Goals of Financial Management”. The financial instruments held for hedging purposes give rise to both counterparty risks and balance sheet risks, which we limit using hedge accounting.
By diversifying when selecting business partners, we ensure that the impact of a default is limited and the Volkswagen Group remains solvent at all times, even in the event of a default by individual counterparties.
Risks arising from trade receivables and from financial services are explained in more detail in the notes to the consolidated financial statements.
Volkswagen is reliant on its ability to ensure that there is adequate coverage for its financing needs. A liquidity risk consists of potentially being unable to ensure existing capital requirements by raising funds or being unable to finance the Group on reasonable terms, which in turn can have substantially negative impact on Volkswagen’s business position, assets, financial position and earnings.
In principle, the Automotive Division and Financial Services Division refinance themselves independently of one another. However, they are subject to very similar refinancing risks. In the Automotive Division, the company’s solvency is ensured at all times mostly through retained, non-distributed earnings, by drawing down on credit lines and by issuing financial instruments on the money and capital markets. The capital requirements of the financial services business are covered mainly by raising funds in the national and international financial markets, as well as through customer deposits from the direct banking business.
Volkswagen finances projects with, for example, loans provided by national development banks such as Kreditanstalt für Wiederaufbau (KfW) or Banco Nacional de Desenvolvimento Econômico e Social (BNDES) or by supranational development banks such as the European Investment Bank (EIB).
In addition to confirmed credit lines, unconfirmed lines of credit from commercial banks supplement our broadly diversified refinancing structure.
Financing opportunities can be hindered by worsening financial and general market conditions, a worsening credit profile and outlook or a downgrade or withdrawal of the credit rating. In such cases, there may be a fall in demand from market participants for securities issued by Volkswagen, which may additionally have a detrimental effect on the interest rates payable and restrict access to the capital market.
As a result of the diesel issue, the ability to use refinancing instruments may possibly be restricted or precluded for the Volkswagen Group. A downgrade of the Company’s rating could adversely affect the terms associated with the Volkswagen Group’s borrowings.
Information on the ratings of Volkswagen AG, Volkswagen Financial Services AG and Volkswagen Bank GmbH can be found in chapter “Ratings”.
Risks in the financial services business
In the course of our financial services activities, we are exposed primarily to residual value risks and credit risks.
A residual value risk arises when the expected fair value for the disposal of the lease or finance asset may be lower than the residual value set at contract conclusion. However, there is an opportunity that disposal of the asset will generate more income than calculated for the residual value.
Referring to the bearer of residual value risk, a distinction is made between direct and indirect residual value risks. A direct residual value risk means that our financial services companies directly bear this risk (as outlined in the contract). An indirect residual value risk occurs when, based on a residual value guarantee, the residual value risk has passed to a third party, such as a dealer. In such cases, an initial counterparty default risk associated with this third party exists (the residual value guarantor). If the guarantor defaults, the residual value risk passes to our financial services companies.
Management of the residual value risk is based on a defined control cycle, which ensures that risks are fully assessed, monitored, responded to and communicated. This process structure enables us to manage residual risks professionally and also to systematically improve and enhance the way we handle residual value risks.
In the course of our risk management, the appropriateness of the risk provision is assessed regularly, as in the residual value risk potential. In the process, we compare the contractually agreed residual values with the obtainable fair values. These are determined utilizing data from external service providers and our own marketing data. We do not take account of the possible gains on residual market values when recognizing loss allowances.
Resulting from potential of residual value risks, a variety of measures are initiated in order to limit these risks. Current market circumstances and future influencing factors must be considered when making a residual value recommendation related to new business.
Credit risk describes the risk of losses due to defaults in customer transactions, specifically by the borrower or lessee. Default occurs when the borrower or lessee is unable or unwilling to make the payments due. This includes late or partial payment of interest and principal on the part of the contracting party.
Credit checks on borrowers are the primary basis for lending decisions. Rating and scoring systems are used to provide an objective decision-making basis for granting loans and leases.
Risks are managed and monitored within the framework of corresponding processes relating to economic circumstances and collateral, adherence to limits, contractual obligations and conditions stipulated both by outside parties and the company itself. As such, commitments are managed according to the degree of risk involved (standard, intensified and problem loan management).
More information on risks in the financial services business can be found in the 2019 annual reports of Volkswagen Financial Services AG and Volkswagen Bank GmbH.