We are exposed to various financial risks, including changes in foreign currency exchange rates, interest rates, equity prices and the creditworthiness of our counterparties.
We manage credit, liquidity, interest rate, equity price and foreign currency exchange rate risks on a Group-wide basis. Selected derivatives are exclusively used for this purpose and not for speculation which is defined as entering into derivative instruments without a corresponding underlying transaction. Financial risk management is done centrally. It is regulated by internal guidelines and undergoes continuous internal risk analysis.
For the presentation of market risks, we use sensitivity analyses that show the effects of hypothetical changes of relevant risk variables on income and other comprehensive income depending whether fair value fluctuations affect earnings or shareholders’ equity. The periodic effects are determined by relating the hypothetical changes in the risk variables to the balance of financial instruments at the reporting date.
The following discussion of our market risk exposure should be read in conjunction with the related Notes 25 and 26 to our consolidated financial statements in “Item 18. Financial Statements.”
FOREIGN CURRENCY EXCHANGE RATE RISK
Foreign currency exchange rate risk is the risk of loss due to adverse changes in foreign exchange rates. As a globally active enterprise, we are subject to risks associated with fluctuations in foreign currencies with regard to our ordinary operations. Foreign currency-denominated receivables, payables, debt, and other monetary balance sheet positions as well as future cash flows resulting from forecasted transactions, including intra-group transactions, are subject to currency risks. Risks from foreign currencies are continuously assessed. Most of these transactions are hedged to the extent that they influence our income and cash flows.
Under U.S. GAAP, foreign exchange risks arise on account of monetary financial instruments denom-inated in currencies other than the functional currency where the nonfunctional currency is the respective risk variable; translation risks are not taken into consideration. Because the individual Group entities mainly conduct their operating business in their own functional currencies, our risk of exchange rate fluctuations from ongoing ordinary operations is not considered significant.
With regard to our investing and financing activities we are not exposed to any significant foreign exchange risk as all activities are conducted in the respective functional currency.
We disclose our risk exposure based on a sensitivity analysis using the following assumptions:
According to our general policy not to invoice in currencies other than the entity’s functional currency, the majority of our nonderivative monetary financial instruments such as cash, accounts receivable, accounts payable, loans to employees and third parties, bank liabilities, and other financial liabilities are denominated in the respective entities’ functional currency. Thus, a foreign exchange risk in these transactions is nonexistent. In exceptional cases and limited economic environments, operating transactions are denominated in currencies other than the functional currency leading to a currency risk for the related monetary instruments. Where we hedge against currency impacts on cash flows, these foreign currency-denominated financial instruments are economically converted into the functional currency by the use of forward exchange contracts or options.
Therefore, fluctuations in foreign currency exchange rates do not have a significant impact on profit and loss or shareholders’ equity with regard to our nonderivative monetary financial instruments.
Furthermore, income or expenses on the nonderivative monetary financial instruments discussed above are always recognized in the relevant entity’s functional currency. Therefore, fluctuations in foreign exchange rates have no significant impact on profit and loss or shareholders’ equity in this regard.
Our freestanding derivatives designed for hedging foreign currency exchange rate risks almost com-pletely balance the changes in the fair values of the hedged item attributable to exchange rate movements in the income statement in the same period. As a consequence, the hedged items and the hedging instruments are not exposed to currency risks with an effect on profit or loss, or shareholders’ equity either.
Consequently, we are only exposed to foreign currency exchange rate fluctuations with regard to:
• derivatives held within a designated cash-flow hedging relationship and
• foreign currency embedded derivatives (which arise for instance due to a foreign-currency denom-inated contract in Switzerland).
As all our cash-flow hedges in a hedge relationship are effective, the fluctuations in the respective currencies affect other comprehensive income. The interest element which is not part of the assigned hedging relationship and is posted to profit and loss is not affected by currency fluctuations. As we do not have a significant exposure to a single currency, we disclose our exposure to our major currencies in total. If, at December 31, 2008, the euro had gained (lost) 10% against all our major currencies, the unrealized foreign currency cash-flow hedge position in other comprehensive income would have been ¤65 million (December 31, 2007: ¤64 million) higher (lower) than presented.
Any change in the value of our foreign currency embedded derivatives is recorded in profit or loss. If, at December 31, 2008, the euro had gained (lost) 10 percent against the Swiss franc, the effect on other nonoperating income would have been ¤40 million (December 31, 2007: ¤37 million) higher (lower) than presented. If at December 31, 2008, the euro had gained (lost) 10 percent against all other currencies, the effect on other nonoperating income would have been ¤3 million (December 31, 2007: ¤3 million) lower (higher) (December 31, 2007: higher (lower)) than presented.
INTEREST RATE RISK
Interest-rate risks result from changes in market interest rates which can cause changes in the fair value of fixed-rate instruments and interest to be paid for variable-rate instruments.
This risk is negligible with regard to our operating activities. Interest rate risks arise on account of our investing activities in debt instruments and our financing activities in connection with financial liabilities. In order to create a balanced structure of fixed and variable financial cash flows, we manage interest-rate risk by adding interest rate-related derivative instruments to a given portfolio of investments and debt financing.
Due to the short maturities of our investments (all our debt securities are classified as current) we do not have a significant interest-rate risk related to financial assets. See Note 13 to our consolidated financial statements in “Item 18. Financial Statements” for a more detailed discussion.
We entered into derivative financial instruments to hedge the interest rate risk resulting from the variable interest rate credit facility in connection with the acquisition of Business Objects.
A sensitivity analysis is provided to show our interest rate risk exposure at the balance sheet date based on the following assumptions:
• Changes in interest rates only affect nonderivative fixed-rate financial instruments if they are recognized at fair value. As we have classified our investments as available for sale we carry interest-rate sensitive debt investments at fair value with fair value changes recognized in other comprehensive income. For this reason, changes in prevailing market rates are included in the equity-related sensitivity calculation.
• Income or expenses for nonderivative financial instruments with variable interest are subject to interest rate risk if they are not hedged items in an effective hedging relationship. We therefore have no significant interest-rate risk arising from our financial liabilities and consider interest rate changes for our variable rate debt investments in the earnings-related sensitivity calculation.
• Due to the aforementioned designation of interest rate derivatives to a cash-flow hedge relationship, the respective interest rate changes affect the unrealized interest rate cash-flow hedge position in other comprehensive income. The movements related to the interest rate swaps’ variable leg are not reflected in the sensitivity calculation as they offset the variable interest payments for the credit facility.
We therefore consider only changes from the interest rate swaps’ fixed leg in the equity-related sensitivity calculation for the interest swaps in a hedge relationship.
• As the deal contingent interest rate payer swaps are freestanding derivatives with fair value fluctuations charged to profit or loss we include only changes from the interest rate swaps’ fixed leg in the earnings-related sensitivity calculation. The movements earnings-related to the interest rate swaps’ variable leg are not reflected in the sensitivity calculation as they offset the variable interest payments for the credit facility.
If, at December 31, 2008, interest rates had been 100 basis points higher (lower), the unrealized gains/losses on marketable securities position in other components of equity would have been ¤0 million (December 31, 2007: ¤2 million) lower (higher) than presented.
If, at December 31, 2008, interest rates for our variable rate debt investments had been 100 basis points higher (lower), the financial income/expense, net would have been ¤3 million (December 31, 2007: ¤1 million) higher (lower) than presented.
If, at December 31, 2008, interest rates had been 100 basis points higher (lower), the Unrealized interest rate cash-flow hedge position in other comprehensive income would have been ¤1 million (December 31, 2007:
¤0 million) lower (higher) than presented.
If, at December 31, 2008, interest rates had been 100 basis points higher (lower), the impact on financial income/expense, net from deal contingent interest rate payer swaps would have been ¤0 million higher (lower) (December 31, 2007: ¤9 million higher and ¤7 million lower, respectively) than presented.
EQUITY PRICE RISK
Equity-price risk is the risk of loss due to adverse changes in equity markets. Our investments consist of listed and non-listed securities held for purposes other than trading and are classified as available for sale. Our equity investments in listed securities are accounted for at fair value with fair value changes recorded in other comprehensive income and are monitored based on the current market value that is affected by the fluctuations in the volatile stock markets worldwide. An assumed 20% increase (decrease) in equity prices as of December 31,
2008 would not have a material impact on the value of our investments in marketable securities (2007:
¤1 million) with corresponding entries in other comprehensive income.
The equity investments in non-listed securities are monitored individually. Those securities are recognized at cost, because market values are generally not observable. They are subject to an annual impairment test.
OTHER RISKS
Share-Based Compensation Hedging
We hedge certain cash flow exposures associated with both recognized and unrecognized share-based compensation through the purchase of derivative instruments from independent financial institutions.
See Notes 25, 26 and 27 to our consolidated financial statements in “Item 18. Financial Statements” for more information regarding our share-based compensation activities, including the detail of the derivative instruments we held as of December 31, 2008 as hedges.
Credit Risk
See Note 26 to our consolidated financial statements in “Item 18. Financial Statements” for a discussion of our credit risk exposure.
Liquidity Risk
See Note 26 to our consolidated financial statements in “Item 18. Financial Statements” for a discussion of our liquidity risk exposure. Also see “ITEM 5. Liquidity and Capital Resources” for more information on our liquidity risk.