33.1
Management of financial and commodity price risks
As a global company, Bayer is exposed in the normal course
of business to currency, interest rate, credit and procurement
market risks that could affect its financial position, results
of operations and cash flows.
It is company policy to use derivative financial instruments
to minimize or eliminate the risks associated with operating
activities and the resulting financing requirements. Derivative
financial instruments are used almost exclusively to hedge
realized or forecasted transactions. The use of derivative
financial instruments is subject to strict internal controls
based on centrally defined mechanisms and uniform guidelines.
The derivatives used are mainly over-the-counter instruments,
particularly forward exchange contracts, option contracts,
interest rate swaps, cross-currency interest-rate swaps, commodity
swaps and commodity option contracts concluded with banks
of first-class credit standing.
The various risk classes and risk management systems are outlined
below:
Currency risk
Exposure to currency risk arises mainly when receivables,
financial liabilities, liquid funds or forecasted transactions
are denominated in a currency other than the company’s
local currency or will be denominated in such a currency in
the planned course of business. The principal currency risks
to which the Bayer Group is exposed involve the U.S. dollar
and the euro.
Currency risk is monitored and analyzed systematically and
is managed centrally by the central finance department. The
scope of hedging is evaluated regularly and defined in a Directive.
Recorded foreign currency operating items and financial items
are normally fully hedged.
The anticipated foreign currency exposure from forecasted
transactions in the next twelve months is hedged on a basis
agreed between the Group Management Board, the central finance
department and the operating units. A significant proportion
of contractual and foreseeable currency risks are hedged through
forward exchange contracts, currency options and currency
swaps.
Interest rate risk
An interest rate risk – the possibility that the value
of a financial instrument (fair value risk) or future cash
flows from a financial instrument (cash flow risk) will change
due to movement in market interest rates – applies mainly
to assets and liabilities with maturities of more than one
year. Such long maturities are only of material significance
in the case of financial assets and liabilities.
Interest rate risk is analyzed centrally in the Bayer Group
and managed by the central finance department using a mix
of fixed and variable interest rates defined by the management
and subject to regular review. Derivatives – mainly
interest rate swaps, cross-currency interest-rate swaps and
interest options – are employed to preserve the target
structure of the portfolio.
Credit risk
In the Bayer Group credit risk arises from the possibility
of asset impairment occurring because counterparties cannot
meet their obligations in transactions involving financial
instruments. Since the Bayer Group does not conclude master
netting arrangements with its customers, the total amounts
recognized in assets represent the maximum exposure to credit
risk.
To minimize the credit risk, predefined exposure limits are
observed and transactions are only conducted with counterparties
of first-class credit standing.
Procurement market risk
The Bayer Group operates in markets in which the prices of
raw material commodities and products often fluctuate. Such
fluctuations can affect business operations. The procurement
departments of the subgroups are responsible for managing
these price risks on the basis of internal directives and
centrally determined limits, which are subject to constant
review. Commodity swaps and commodity options, in particular,
are employed to hedge changes in the prices of crude oil,
naphtha and benzene feedstocks and of natural gas.
These instruments are also used in the case of long-term,
fixed-price supply contracts.
33.2 Primary
financial instruments
Primary financial instruments are reflected in the balance
sheet. In compliance with IAS 39 (Financial Instruments: Recognition
and Measurement), asset instruments are classified as “financial
assets held for trading,” “held-to-maturity investments,”
“loans and receivables” or “available-for-sale
financial assets.” Held-to-maturity investments, and
loans and receivables, are recognized at amortized cost, while
assets held for trading or available for sale are stated at
fair value. Changes in the fair value of available-for-sale
securities are recognized in stockholders’ equity, except
in the case of impairment losses, which are recognized in
income.
Primary financial instruments constituting liabilities are
carried at amortized cost unless they are designated for hedge
accounting together with a derivative.
The amount of financial liabilities recognized in the balance
sheet is EUR 37 million (2004: EUR 566 million) below their
fair value, which is determined mainly by discounting future
cash flows. The fair value of a primary financial instrument
is the price at which it could be exchanged in a current transaction
between knowledgeable, willing parties in an active market.
The remaining receivables and liabilities and the liquid assets
have such short terms that there is no significant discrepancy
between their fair values and carrying amounts.
33.3 Economic
hedges and hedge accounting with derivative financial instruments
The Bayer Group uses derivative financial instruments to mitigate
the risk of changes in exchange rates, interest rates and
commodity prices. Many transactions constitute economic hedges
but do not qualify for hedge accounting under IAS 39. Changes
in the fair value of these derivative financial instruments
are recognized directly in the income statement: fair value
changes on forward exchange contracts and currency options
are reflected in exchange gains and losses, those on interest-rate
swaps and interest-rate options in interest income and expense,
and those on commodity futures and commodity options in other
operating income and expenses. The fair values of derivatives
are determined from quoted market prices or using recognized
mathematical valuation methods.
Changes in the fair values of derivative financial instruments
designated as fair value hedges are
recognized along with the underlying transaction.
Changes in the fair value of the effective portion of derivatives
designated as cash flow hedges are initially recognized not
in the income statement, but in stockholders’ equity
as other comprehensive income. They are released to the income
statement when the underlying transaction is realized. The
effects of hedging forecasted transactions denominated in
foreign currencies and the effects of commodity hedges are
recognized in other operating income and expense at the date
of realization. If a derivative is sold or ceases to qualify
for hedge accounting, the amount reflected in other comprehensive
income continues to be recognized in this item until the forecasted
transaction is realized. If the forecasted transaction is
no longer probable, the amount previously recognized in other
comprehensive income is released to the income statement.
The income and expense from the derivatives and the underlying
transactions reflected in the non-operating result are shown
separately. Income and expense are not offset.
The fair value of hedged transactions at year end was as follows:
| |
Dec.
31, 2004 |
Dec.
31, 2005 |
| |
|
Fair
value |
|
Fair value |
| |
Notional amount |
Positive fair
value |
Negative fair
value |
Notional
amount |
Positive
fair value |
Negative
fair value |
| EUR million |
|
|
|
|
|
|
| Currency hedging of recorded transactions |
5,854 |
505 |
(45) |
4,759 |
18 |
(105) |
| Forward exchange contracts |
4,420 |
108 |
(45) |
3,600 |
15 |
(34) |
| of which FV hedges |
75 |
0 |
(3) |
0 |
0 |
0 |
| of which CF hedges |
|
|
|
|
|
|
| Currency options |
20 |
1 |
|
44 |
1 |
(1) |
| of which FV hedges |
|
|
|
0 |
|
|
| of which CF hedges |
|
|
|
|
|
|
| Cross-currency interest-rate swaps |
1,414 |
396 |
0 |
1,115 |
2 |
(70) |
| of which FV hedges |
182 |
92 |
0 |
|
|
|
| of which CF hedges |
459 |
45 |
0 |
460 |
|
(10) |
| |
|
|
|
|
|
|
| Currency hedging of forecasted transactions |
479 |
31 |
(1) |
942 |
10 |
(40) |
| Forward exchange contracts |
376 |
22 |
(1) |
817 |
5 |
(33) |
| of which FV hedges |
|
|
|
|
|
|
| of which CF hedges |
371 |
22 |
(1) |
809 |
5 |
(33) |
| Currency options |
103 |
9 |
|
125 |
5 |
(7) |
| of which FV hedges |
|
|
|
|
|
|
| of which CF hedges |
103 |
9 |
– |
93 |
3 |
(7) |
| |
|
|
|
|
|
|
| Interest rate hedging of recorded transactions |
5,791 |
198 |
(49) |
11,327 |
174 |
(66) |
| Interest rate swaps |
5,791 |
198 |
(49) |
10,327 |
172 |
(65) |
| of which FV hedges |
4,104 |
176 |
(1) |
5,533 |
30 |
(31) |
| of which CF hedges |
575 |
0 |
(29) |
|
|
|
| Interest rate options |
|
|
|
1,000 |
2 |
(1) |
| of which FV hedges |
|
|
|
|
|
|
| of which CF hedges |
|
|
|
|
|
|
| |
|
|
|
|
|
|
| Commodity price hedging |
802 |
59 |
(31) |
465 |
280 |
(209) |
| Forward commodity contracts |
802 |
59 |
(31) |
416 |
210 |
(125) |
| of which FV hedges |
|
|
|
0 |
0 |
|
| of which CF hedges |
10 |
2 |
|
168 |
70 |
(1) |
| Commodity option contracts |
|
|
|
49 |
70 |
(84) |
| of which FV hedges |
|
|
|
|
|
|
| of which CF hedges |
|
|
|
|
|
|
| |
|
|
|
|
|
|
| Total |
12,926 |
793 |
(126) |
17,493 |
482 |
(420) |
of which short-term
derivative financial
instruments |
6,468 |
547 |
(54) |
5,443 |
116 |
(161) |
for currency
hedging |
5,864 |
488 |
(46) |
4,872 |
29 |
(155) |
for interest rate
hedging |
109 |
26 |
(1) |
350 |
0 |
|
for commodity
hedging |
495 |
33 |
(7) |
221 |
87 |
(6) |
Fair value hedges
Fair value hedges are used to eliminate the risk of changes
in fair value, especially on fixed-interest borrowings, by
obtaining a variable interest rate. Essentially these fair
value hedges comprise the EUR 2 billion bond issued in 2002
and the EUR 1.3 billion bond issued in 2005, along with
the bond issued in 2002, which was partially repurchased in
2005 and has a remaining principal amount of EUR 2.1 billion.
The ineffective portion of fair value hedges amounts to EUR 0
million (2004: EUR 6 million).
As in the previous year, there are no effects resulting from
premature termination of fair value hedges entered into on
the basis of firm commitments.
Cash flow hedges
Fluctuations in future cash flows from forecasted foreign
currency transactions are avoided by means of cash flow hedges.
Cash flow hedges are also used to partially limit the risk
of fluctuations in future cash flows resulting from price
fluctuations on procurement markets. They relate to forecasted
foreign currency transactions or procurement transactions
with total notional volumes of EUR 942 million and EUR 465
million (2004: EUR 479 million and EUR 802 million), respectively.
As of December 31, 2005, cash flow hedges totaling EUR 7
million (2004: EUR 27 million) were recognized in other
comprehensive income, while EUR 3 million (2004: EUR 1
million) were removed from other comprehensive income and
released to the income statement. The ineffective portion
of hedges totaling EUR 10 million (2004: EUR 0 million)
are recognized in income.
An amount of EUR 56 million will probably be reclassified
from other comprehensive income to the income statement within
the next twelve months. All forecasted transactions are considered
highly probable.
34. Commitments
and contingencies
Contingent liabilities as of December 31, 2005 amounted
to EUR 177 million. They result entirely from liabilities
assumed on behalf of third parties and comprise:
| |
Dec. 31, 2004 |
Dec. 31, 2005 |
| EUR million |
|
|
| Issuance and endorsement of bills |
7 |
12 |
| Guarantees |
70 |
93 |
| Other commitments |
117 |
72 |
| |
194 |
177 |
The respective items refer to potential future obligations where
the occurrence of the future events would create an obligation,
the existence of which is uncertain at the balance sheet date.
Group companies frequently enter into certain obligations related
to business transactions. These mainly comprise commitments
undertaken by subsidiaries for a defined level of performance
or the rendering of a specific service. Guarantees comprise
mainly bank guarantees where subsidiaries guarantee third parties’
liabilities to banks resulting from contractual agreements with
these subsidiaries. A liability to perform under the guarantee
arises if the debtor is in arrears with payments or is insolvent.
Litigation and administrative proceedings are evaluated on a
case-by-case basis considering the available information, including
that from legal counsel, to assess potential outcomes. Where
it is considered probable that a future obligation will result
in an outflow of resources, a provision is recorded in the amount
of the present value of the expected cash outflows if these
are deemed to be reliably measurable. Litigation and other judicial
proceedings as a rule raise difficult and complex legal issues
and are subject to many uncertainties and complexities including,
but not limited to, the facts and circumstances of each particular
case, issues regarding the jurisdiction in which each suit is
brought and differences in applicable law. Such proceedings
therefore cannot be included in contingent liabilities. Further
details of legal risks are given in Note
[35].
Under the German Transformation Act, Bayer AG and LANXESS AG
are jointly and severally liable for all obligations of Bayer
AG that existed on January 28, 2005. To the extent that certain
obligations were not assigned to Bayer AG under the Spin-off
and Acquisition Agreement, dated September 22, 2004, between
Bayer AG and LANXESS AG, Bayer AG ceases to be liable for such
obligations after a five-year period. The Master Agreement,
entered into between the same parties contemporaneously with
the Spin-off and Acquisition Agreement, includes corresponding
indemnification obligations of Bayer AG and LANXESS AG. It also
contains provisions dealing with the apportionment of liabilities
arising from product liability claims, environmental claims
and antitrust violations as between the contracting parties.
In addition to provisions, other liabilities and contingent
liabilities, there are also other financial
commitments. Further financial commitments also exist, mainly
under long-term lease and rental agreements.
Minimum non-discounted future payments relating to operating
leases total EUR 452 million (2004: EUR 441 million). The respective
payment obligations mature as follows:
| Maturing in |
Dec. 31, 2004 |
| EUR million |
|
| 2005 |
96 |
| 2006 |
80 |
| 2007 |
69 |
| 2008 |
59 |
| 2009 |
51 |
| 2010 or later |
86 |
| |
441 |
|
|
| Maturing in |
Dec. 31, 2005 |
| EUR million |
|
| 2006 |
106 |
| 2007 |
90 |
| 2008 |
71 |
| 2009 |
62 |
| 2010 |
49 |
| 2011 or later |
74 |
| |
452 |
|
Financial commitments resulting from orders already placed
under purchase agreements related to planned or ongoing capital
expenditure projects total EUR 294 million (2004: EUR 142
million).
Of the respective payments, EUR 292 million – almost
the entire amount – is due in 2006.
In addition, the Group has entered into research agreements
with a number of third parties under which Bayer has agreed
to fund various research projects or has assumed other commitments
based on the achievement of certain milestones or other specific
conditions. The total amount of such funding and other commitments
is EUR 562 million (2004: EUR 847 million). At December
31, 2005, the remaining payments expected to be made to these
parties, assuming the milestones or other conditions are met,
were as follows:.
| Maturing in |
Dec. 31, 2004 |
| EUR million |
|
| 2005 |
193 |
| 2006 |
153 |
| 2007 |
165 |
| 2008 |
76 |
| 2009 |
93 |
| 2010 or later |
167 |
| |
847 |
|
|
| Maturing in |
Dec. 31, 2005 |
| EUR million |
|
| 2006 |
109 |
| 2007 |
111 |
| 2008 |
82 |
| 2009 |
93 |
| 2010 |
85 |
| 2011 or later |
82 |
| |
562 |
|
|
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