For this risk category, the likelihood of occurrence is classified as high (previous year: high) and the potential extent of damage is classified as medium (previous year: medium).
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 – but also from unforeseeable events such as the Covid-19 pandemic. Management of these financial risks and of 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.
Interest rate risk refers to potential losses that could arise as a result of changes in market interest rates. It occurs because of interest rate mismatches between asset and liability items in a portfolio or on the balance sheet. 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. The principle of matching amounts and maturities applies to financing arrangements within the Volkswagen Group in the Automotive Division. In the Financial Services Division, the risk of changes in the interest rate is managed on the basis of limits using interest rate derivatives as part of the defined risk strategy.
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 use these to 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 particularly 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. For selected commodities, this may also involve increases in physical inventories. We have also entered into transactions in order to supplement and improve allocations of CO2 emission certificates as part of the European Union Emissions Trading System (EU ETS).
Special funds in which we invest surplus liquidity may entail equity price risks and fund price risks. We reduce these risks through the diversified investment of funds and through minimum values set out in the respective investment guidelines. In addition, exchange rates are hedged when market conditions are appropriate.
In the notes to the consolidated financial statements we explain our hedging policy, the hedging rules and the default and liquidity risks, and quantify the hedging transactions mentioned. We also disclose information on market risk within the meaning of IFRS 7 in the same section.
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 chapter entitled “Principles and Goals of Financial Management” in the “Results of Operations, Financial Position and Net Assets” chapter. 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.
Volkswagen is reliant on its ability to adequately cover its financing needs. A liquidity risk consists of potentially being unable to cover existing capital requirements by raising funds or being unable to finance the Group on reasonable terms, which in turn can have a 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.
One of the ways in which Volkswagen finances its projects is with 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.
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 – including as a result of the Covid-19 pandemic – a worsening credit profile and outlook or a downgrade or withdrawal of the credit rating. In such cases, there is a risk of 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.
Risks and opportunities in the financial services business
While carrying out our financial services activities, we are primarily exposed 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 also a possibility 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, there is an initial counterparty default risk associated with this third party (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.
As part of our risk management efforts, the appropriateness of the risk provision is assessed regularly, as is 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 possible gains on residual market values into account when recognizing risk provisions.
Based on the resulting potential residual value risk, a variety of measures are initiated in order to limit this risk. With respect to new business, current market circumstances and future influencing factors must be considered in the residual value recommendation.
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 and for recognizing risk provisions.
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.
An opportunity may arise if the losses from the lending and leasing business are less than the expected losses previously calculated and the risk provision recognized on this basis. In some countries in particular, where we take a conservative approach to risk due to the uncertain economic situation, a stabilization of the economy, accompanied by an improvement in borrowers’ credit rating, provides an opportunity for realized losses to be less than expected losses.
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 2020 annual reports of Volkswagen Financial Services AG and Volkswagen Bank GmbH.