4. FINANCIAL RISK MANAGEMENT POLICIES

The Group is exposed to financial risks. These are principally associated with foreign exchange rates, fluctuations in interest rates, the price of financial assets held as investments, the ability of customers to honour their obligations to the Group (credit risk), and raising funds on the market (liquidity risk).

Financial risk management is an integral part of managing the Group’s business. It is carried out centrally in accordance with guidelines issued by the Finance Department on the basis of general risk management strategies defined by the Managerial Risk Committee.

 

Types of financial risks

Exchange rate risk

The varied geographical distribution of Group production and commercial activities entails exposure to transaction exchange rate risk and currency translation risk.

a) transaction exchange rate risk

This risk is generated by the commercial and financial transactions of the individual companies that are executed in currencies other than the functional currency. Exchange rate fluctuations between the time when the commercial or financial relationship is established and when the transaction is completed (collection or payment) may generate foreign exchange gains or losses.

The Group aims to minimise the impact of transaction exchange rate risk on the income statement. To do so, Group procedures make the operating units responsible for collecting complete information about the assets and liabilities that are subject to transaction exchange rate risk. This risk is hedged with forward contracts made with the Group Treasury. The items subject to exchange rate risk are mainly represented by receivables and payables denominated in foreign currency.

The Group Treasury is responsible for hedging the net position for each currency. In accordance with established guidelines and restrictions, it closes all risk positions by trading derivative hedging contracts on the market, which typically take the form of forward contracts.

The Group has decided not to opt for hedge accounting pursuant to IAS 39, insofar as representation of the effects of the transaction exchange risk hedging strategy in the income statement and equity is substantially guaranteed even without adopting hedge accounting.

Furthermore, as part of the annual and three-year planning process, the Group makes exchange rate forecasts according to these time horizons by using the best information available on the market. The fluctuation in exchange rates between the time when the forecast is made and the time when the commercial or financial transaction is established represents the transaction exchange rate risk on future transactions.

In accordance with established policy, the Group monitors the opportunity to hedge future transactions, with each hedge being authorised by the Finance Department on a case-by-case basis. Hedge accounting in accordance with IAS 39 is used when the conditions for doing so are satisfied.

b) translation exchange rate risk

The Group owns controlling interests in companies that prepare their financial statements in currencies other than the euro, which is the Group presentation currency. This exposes the Group to translation exchange rate risk, which is generated by the conversion of assets and liabilities of those subsidiaries into euro.

The principal exposures to translation exchange rate risk are constantly monitored, but the Group has no policy to hedge this exposure.

About 27% of total consolidated net equity at December 31, 2011 was expressed in euro (about 35% at December 31, 2010). The most important currencies for the Group other than the euro are the Brazilian Real (22%; 25% at December 31, 2010), the Turkish Lira (8%; 10% at December 31, 2010), the Chinese Renminbi (9%; 6% at December 31, 2010), and the Romanian Leu (8%; 8% at December 31, 2010).

The tables below shows the effects on consolidated equity deriving from a hypothetical appreciation/ depreciation of the above currencies against the euro, with all other conditions being equal:

(in thousands of euro)
  
APPRECIATION OF 10% DEPRECIATION OF 10%
12/31/2011 12/31/2010 12/31/2011 12/31/2010
Brazilian real 52,474 55,967 (42,933) (45,791)
Turkish lira 19,929 22,989 (16,305) (18,809)
Chinese renminbi 21,640 12,800 (17,705) (10,473)
Romanian leu 20,185 17,867 (16,515) (14,618)
Total out of consolidated equity 114,228 109,623 (93,458) (89,691)

 

Interest rate risk

Interest rate risk is the risk that the fair value or the future cash flows of a financial asset or liability will change due to fluctuations in market interest rates.

Group policy is to attempt to maintain the following ratio between fixed rate and variable rate exposures: 65% fixed and 35% variable.

The Group makes derivative contracts, typically interest rate swaps with hedging objective in order to maintain this target ratio. For such derivatives hedge accounting is adopted when the conditions set by IAS 39 are met.

The table below shows the effects on net income (loss) and direct effects on equity deriving from an increase or decrease of 0.50% in the level of interest rates of all currencies to which the Group is exposed – all other conditions being equal:

(in thousands of euro)
 
+0.50% -0.50%
12/31/2011 12/31/2010 12/31/2011 12/31/2010
IMPACT ON NET INCOME (LOSS):     
- Companies consolidated line-by-line (2,914) (388) 2,760 388
TOTAL (2,914) (388) 2,760 388
DIRECT IMPACT ON EQUITY:     
- Companies consolidated line-by-line 7,373 8,488 (12,785) (15,502)
TOTAL 7,373 8,488 (12,785) (15,502)

 

Price risk associated with financial assets

The Group’s exposure to price risk is limited to the volatility of financial assets such as listed and unlisted equities and bonds, for approximately 4.1% of total consolidated assets at December 31, 2011 (7% at December 31, 2010). Such assets are classified as available-for-sale financial assets or financial assets held for trading.

Derivatives contracts that would limit the volatility of these assets are not normally made.

The available-for-sale financial assets, represented by listed equity instruments, total euro 82,202 thousand (euro 131,412 thousand at December 31, 2010) and represent 28.6% of all financial assets subject to price risk (33.2% at December 31, 2010). A 1% change in the aforementioned listed securities, all else being equal, would entail a change of euro 797 thousand (euro 1,306 thousand at December 31, 2010) in the Group’s equity.

Credit risk

Credit risk represents Group exposure to contingent losses resulting from default by commercial and financial counterparties.

The Group is exposed to credit risk as part of its operating activities and financing activities.

To limit commercial counterparty default risk, the Group has implemented procedures to evaluate its customers’ potential and financial solidity, monitor expected incoming cash flows and take credit recovery action if necessary.

The aim of these procedures is to define customer credit limits. Further sales are suspended when those limits are exceeded.

In some cases customers are asked to provide guarantees. These are mainly bank guarantees, issued by parties with the highest credit standing, or personal guarantees. Less frequently, mortgage guarantees may be requested.

Insurance policies are another instrument used to manage commercial credit risk. These policies aim to prevent the risk of non-payment through careful selection of covered customers in collaboration with the insurance company, which undertakes to indemnify the Group in the event of customer insolvency.

The Group deals only with highly rated financial counterparties for the management of temporary surplus cash or for trading in derivatives (with the exception of the euro 160 million loan granted to Prelios S.p.A. as part of the demerger of Pirelli RE from the Pirelli Group, and renewed in 2011 with a due date of July 2017) and constantly monitors its exposure to individual counterparties. The Group does not hold public debt instruments of any European country and constantly monitors its net credit exposure to the banking system.

The Group does not have significant concentrations of credit risk.

The disclosure related to the maximum credit exposure, which is represented by the gross receivables, is included in note 15 “Trade receivables” and note 16 “Other receivables.”

Liquidity risk

Liquidity risk represents the risk that the Company’s available financial resources be insufficient to meet its financial and commercial obligations pursuant to the contractual terms and conditions.

The principal instruments used by the Group to manage liquidity risk are comprised by its annual and three-year financial plans and cash-pooling plans. These allow complete and fair monitoring and measurement of incoming and outgoing cash flows. The differences between the plans and the actual figures are constantly analysed.

The Group has implemented a centralised cash pooling system for the management of collection and payment flows in compliance with various local currency and tax laws. Banking relationships are negotiated and managed centrally, in order to ensure coverage of short and medium-term financial needs at the lowest possible cost. The procurement of medium and long-term resources on the capital market is also streamlined through centralised management.

Prudent management of the risk described above requires maintaining an adequate level of cash equivalents and/or highly liquid short-term financial instruments, and the availability of funds through an adequate amount of committed credit facilities and/or recourse to the capital market.

At December 31, 2011 the Group had, besides cash and securities held for trading of euro 717,486 thousand, unused committed credit facilities of euro 840,000 thousand (euro 1,220,000 thousand at December 31, 2010), with the following maturities:

(in thousands of euro)
  12/31/2011 12/31/2010
2011 -
20,000
2015 840,000 1,200,000
  840,000 1,200,000

 

The change from December 31, 2010 is due to use of euro 360,000 thousand of the syndicated credit facility that totals euro 1,200,000 thousand (granted to Pirelli & C. S.p.A., Pirelli Tyre S.p.A. and Pirelli International Limited), which was not used last year.

The maturities of financial liabilities at December 31, 2011 can be broken down as follows:

(in thousands of euro)
  WITHIN 1 YEAR 1 TO 2 YEARS 2 TO 5 YEARS OVER 5 YEARS TOTAL
Trade payables 1,382,772 - - - 1,382,772
Other payables 626,811 1,120 48,385 4,475 680,791
Financial instruments 103,912 - - - 103,912
Borrowing from banks and other financial institutions 369,451 100,631 1,227,373 74,493 1,771,948
  2,482,946 101,751 1,275,758 78,968 3,939,423

 

The use of the syndicated credit facility (granted to Pirelli & C. S.p.A., Pirelli Tyre S.p.A. and Pirelli International Limited) of Euro 360,000 thousand at December 31, 2011 has been classified under non-current borrowings from banks and other financial institutions due in 2015 (from 2 to 5 years). See note 25.

The maturities of financial liabilities at December 31, 2010 can be broken down as follows:

(in thousands of euro)
  WITHIN 1 YEAR 1 TO 2 YEARS 2 TO 5 YEARS OVER 5 YEARS TOTAL
Trade payables 1,066,361 - - - 1,066,361
Other payables 403,373 3,243 34,773 3,648 445,037
Financial instruments 69,914 - - - 69,914
Borrowing from banks and other financial institutions 247,515 146,833 624,967 122,911 1,142,226
  1,787,163 150,076 659,740 126,559 2,723,538

 

Additional information : categories of financial assets and liabilities

The table below shows the carrying amounts for each class of financial asset and liability identified by IAS 39:

(in thousands of euro)
  NOTE CARRYING AMOUNT
AT 12/31/2011
CARRYING AMOUNT
AT 12/31/2010
FINANCIAL ASSETS    
Financial assets carried at fair value through profit or loss    
Securities held for trading 19 160,503 209,770
Current derivative financial instruments 28 62,281 33,454
Loans and receivables    
Non-current other receivables 16 347,870 315,531
Current trade receivables 15 745,238 676,681
Current other receivables 16 281,737 174,982
Cash and cash equivalents 20 556,983 244,725
Available-for-sale financial assets    
Non-current other financial assets 13 127,037 185,267
Hedging financial instruments      
Current derivative financial instruments 28 8,065 1,705
    2,289,714 1,842,115
 
FINANCIAL LIABILITIES    
Financial liabilities carried at fair value trough profit or loss   
Current derivative financial instruments 28 51,795 41,896
Financial liabilities carried at amortised cost    
Non-current borrowings from banks and other financial institutions 25 1,402,497 894,711
Non-current other payables 27 53,980 41,664
Current borrowings from banks and other financial institutions 25 369,451 247,515
Current trade payables 26 1,382,772 1,066,361
Current other payables 27 626,811 403,373
Hedging financial instruments    
Current derivative financial instruments 28 52,117 28,018
    3,939,423 2,723,538

 

Additional information : fair value hierarchy 

The classification of financial instruments carried at fair value on the basis of a hierarchy of levels pursuant to IFRS 7 is illustrated as follows. This hierarchy reflects the significance of the inputs used to determine fair value. The following levels are distinguished:

  • Level 1 – unadjusted quotations recorded on an active market for the assets or liabilities to be measured;
  • Level 2 – inputs different from the quoted prices referred to at the preceding sub-indent, and that are observable on the market either directly (as in the case of prices) or indirectly (because they are derived from prices);
  • Level 3 – inputs that are not based on observable market data.

The following table shows assets and liabilities carried at fair value at December 31, 2011, divided into the three levels defined above:

2011 (in thousands of euro)      
  NOTE CARRYING AMOUNT
AT 12/31/2011
LEVEL 1 LEVEL 2 LEVEL 3
FINANCIAL ASSETS     
Financial assets carried at fair valuethrough profit or loss:      
Securities held for trading 19 160,503 832 159,671 -
Current derivative financial instruments 28 62,281 - 62,281 -
Hedging financial instruments:      
Current derivative financial instruments 28 8,065 - 8,065 -
Available-for-sale financial assets:      
Equities   114,664 71,229 10,943 32,492
Investments funds   12,373 30 12,343 -
  13 127,037 71,259 23,286 32,492
TOTAL ASSETS   357,886 72,091 253,303 32,492
 
FINANCIAL LIABILITIES     
Financial liabilities carried at fair valuethrough profit or loss:      
Current derivative financial instruments 28 (51,795) - (51,795) -
Hedging financial instruments:      
Current derivative financial instruments 28 (52,117) - (52,117) -
TOTAL LIABILITIES   (103,912) - (103,912)  

 

The situation at December 31, 2010 was as follows:

2010 (in thousands of euro)      
  NOTE CARRYNG AMOUNT
AT 12/31/2010
LEVEL 1 LEVEL 2 LEVEL 3
FINANCIAL ASSETS     
Financial assets carried at fair valuethrough profit or loss:      
Securities held for trading 19 209,770 11,910 197,860 -
Current derivative financial instruments 28 33,454 - 33,454 -
Hedging financial instruments:      
Current derivative financial instruments 28 1,705 - 1,705 -
Available-for-sale financial assets:      
Equities   171,969 115,724 15,641 40,604
Investments funds   13,298 48 13,250 -
  13 185,267 115,772 28,891 40,604
TOTAL ASSETS   430,196 127,682 261,910 40,604
 
FINANCIAL LIABILITIES     
Financial liabilities carried at fair valuethrough profit or loss:      
Current derivative financial instruments 28 (41,896) - (41,896) -
Hedging financial instruments:      
Current derivative financial instruments 28 (28,018) - (28,018) -
TOTAL LIABILITIES   (69,914) - (69,914) -

 

During 2011, there were no transfers from level 1 to level 2 or vice-versa.

The following table shows the changes that occurred in level 3 during 2011:

(in thousands of euro)
  12/31/2011 12/31/2010
Opening balance 40,604 51,167
Discontinued operations - (2,781)
Increases / Subscription of capital 1,824 1,848
Disposals (5,274) -
Impairment (11,449) (5,743)
Fair value adjustment through Equity (3,341) (4,087)
(Gains) losses transferred to income statement upon disposal or upon impairment, previously recognised in Equity 10,300 -
Other changes (172) 200
Closing balance 32,492 40,604

 

The disposals refer mainly to the equity investment in Gruppo Banca Leonardo S.p.A. for euro 5,155 thousand.

Impairment refers mainly to reclassification in the income statement of the loss on the equity investment in Alitalia S.p.A. (euro 10,300 thousand) that was previously recognised in equity, as stated in the following item “(gains) losses transferred to income statement”.

The fair value adjustment through equity refers mainly to Alitalia S.p.A. (euro 3,105 thousand). During the year, there were no transfers from level 3 to other levels or vice-versa.

The fair value of financial instruments traded on active markets is based on the price quotations published at the reporting date. These instruments, included in level 1, mainly consist of equity investments classified as held for trading or available for sale.

The fair value of financial instruments not traded on active markets (e.g. derivatives) is measured by means of techniques that maximise the use of observable and available market data. If the most material data for determining the fair value of a financial instrument are observable, the instrument is included in level 2. The measurement techniques used to determine the fair value of these instruments include:

  • market prices for similar instruments;
  • the fair value of interest rate swaps is calculated by discounting estimated future cash flows based on observable yield curves;
  • the fair value of foreign exchange derivatives (forward contracts) is determined by using the forward exchange rate at the reporting date.