The term “financial risks” refers to fluctuations in Swedish Match’s cash flow caused by changes in foreign exchange rates and interest rates, and to risks associated with refinancing and credit. To manage its financial risks, Swedish Match has a finance policy in place established by the Board of Directors. The Group’s finance policy comprises a framework of guidelines and rules governing the management of financial risks and finance operations in general.
Financial instruments
Swedish Match uses various types of financial instruments to hedge the Group’s financial exposure arising in business operations and as a result of the Group’s financing and asset and debt management activities. In addition to loans, investments and spot instruments, derivative instruments are used to reduce Swedish Match’s financial exposure. The most frequently used derivative instruments are currency forwards, currency swaps and interest rate swaps.
Currency risks
Exchange rate fluctuations affect Group earnings and shareholders’ equity in various ways:
- Earnings – when sales revenues and production costs are denominated in different currencies (transaction exposure).
- Earnings – when the earnings of foreign subsidiaries are translated to SEK (translation exposure).
- Earnings – if loans and deposits are made in other currencies than the unit’s functional currency (translation exposure).
- Shareholders’ equity – when the net assets of foreign subsidiaries are translated to SEK (translation exposure).
Transaction exposure
For the Group as a whole, there is a balance between inflows and outflows in the major currencies EUR and USD, which effectively limits the Group’s transaction exposure. Limited transaction exposure arises when certain of the Group’s production units in Europe make purchases of raw tobacco in USD, and through the European operations’ exports of lighters and matches in USD. This exposure has been reduced following the STG transaction.
The anticipated commercial currency flow net of the reverse flows in the same currencies (transaction exposure) amounts to approximately 750 MSEK on an annual basis. It is divided as following; 400 MSEK in NOK (53 percent), 95 MSEK in EUR (13 percent), 70 MSEK in GBP (9 percent), 40 MSEK in USD (5 percent), 40 MSEK in PHP (5 percent), 35 MSEK in TRY (5 percent), and in other currencies 70 MSEK (9 percent). Swedish Match’s policy for managing the Group’s transaction exposure is to hedge within certain limits. The hedging transactions are, if any, based on risk exposures, current market conditions and other strategic considerations. Transactions are mainly initiated via currency forward contracts with durations of up to 12 months, and relate to forecasted currency flows. At December 31, 2010, the exposure was limited and therefore no transaction exposure for 2011 has been hedged. A general rise of 1 percent in the value of the SEK against all of the Group’s transaction currencies is estimated to reduce consolidated earnings before tax by 7 MSEK (4) for the year ending December 31, 2010.
Translation exposure
The most significant effect of currency movements on consolidated earnings arises from the translation of subsidiaries’ earnings. Earnings in Group companies are translated at average exchange rates. Significant effects mainly pertain to USD, EUR and BRL. The single most important currency is the USD. When the net assets of foreign subsidiaries are translated to SEK, translation differences arise that are recognized directly in equity. The exposures of net investment are 1,955 MSEK in USD (46 percent), 1,720 MSEK in EUR (40 percent) and in other currencies 590 MSEK (14 percent). The Group does not, as a general rule, hedge the net investments in foreign subsidiaries. If the SEK weakened by 1 percent against all the currencies in which Swedish Match has foreign net assets, the effect on shareholders’ equity would be positive in an amount of approximately 45 MSEK, based on the exposure at December 31, 2010.
Interest-rate risk
The Swedish Match Group’s sources of financing mainly comprise shareholders’ equity, cash-flow from current operations, and borrowing. Interest-bearing loans and pension liabilities expose the Group to interest-rate risk. Changes in interest rates have a direct impact on Swedish Match’s net interest expense. Swedish Match policy is that the average interest maturity should be less than 5 years. The speed with which a permanent change of interest rate impacts net interest expense depends on the interest maturity periods of the loans. The Group’s objective for interest rate binding is to achieve an even and low cost of interest. Interest rate swaps and currency swaps are used mainly to convert our borrowing into SEK and fixed interest rates. At December 31, 2010, the average interest maturity period for Group loans was 4.0 years (2.8 years), taking into account interest rate swaps.
Refinancing risk and liquidity
Refinancing risk is defined as the risk of that funds become scarce and thus more expensive than expected, and liquidity risk is defined as not being able to make regular payments as a consequence of inadequate liquidity or difficulty in raising external loans. Swedish Match applies a centralized approach to the Group’s financing, whereby as much external borrowing as possible is conducted centrally. Subsidiary borrowing can take place, however, in countries where regulations and taxes make central financing impossible or uneconomical. Swedish Match tries to limit its refinancing risk by having a good distribution and a certain length on its gross borrowing, and not to be dependent on individual sources of financing.
Liquidity within Swedish Match is handled centrally through local cash pools. Group companies are required to deposit liquid funds in cash pool accounts or, if these are not available, with the Parent Company’s treasury units. Exceptions are only allowed when regulations prohibit cash pools or internal deposits.
Liquidity risks and credit risks
To limit liquidity and credit risks, investments and transactions in derivative instruments may be made only in instruments with high liquidity and with counterparties having high credit ratings. In addition to bank accounts, Swedish Match invests surplus funds mainly in government bonds, treasury bills and bank and mortgage certificates, as well as in certain approved securities with approved counterparties. At December 31, 2010, the average interest maturity for the Group’s current investments was approximately 0.3 months.
The Group’s finance policy regulates the maximum credit exposure to various counterparties. The aim is that counterparties to Swedish Match in financial transactions should have a credit rating of at least A from Standard & Poor’s or equivalent from Moody’s. To reduce the credit risk in receivables from banks arising via derivative instruments, Swedish Match has entered into netting agreements, known as ISDA Master Agreements, with all of its counterparties. At December 31, 2010, credit exposure in derivative instruments amounted to 14 MSEK, and credit exposure in cash and deposits at banks amounted to 3,275MSEK. Swedish Match reduces the risk of its customers failing to fulfi ll their undertakings with the result that payment is not received for accounts receivable, by dividing accounts receivable among many different customers. At the reporting date, there was no signifi cant concentration of credit risk in the Group’s accounts receivable. The total amount of the Group’s trade receivables was 1,181 MSEK.
Source: Swedish Match Annual Report 2010, Note 27 Financial instruments and financial risks.