Telstra Corporation Limited – Annual report – 30 June 2018
4.3 Capital management (extract)
Derivatives are financial instruments that derive their value from the price of an underlying item such as interest rate, foreign currency exchange rate, credit spread or other index.
Table E shows the carrying value of each class of derivative financial instruments.
The terms of a derivative contract are determined at inception, therefore any movements in the price of the underlying item over time will cause the contract value to constantly fluctuate, which is reflected in the fair value of the derivative. Derivatives which are in an asset position (i.e. the market has moved in our favour) are referred to as being ‘in the money’ and derivatives in a liability position as ‘out of the money’.
Both parties are therefore exposed to the credit quality of the counterparty. We are exposed to credit risk on derivative assets as a result of the potential failure of the counterparties to meet their contractual obligations. We do not have credit risk associated with derivatives that are out of the money.
Refer to note 4.4.3 for information about our credit risk policies.
(a) Recognition and measurement
Derivative financial instruments are:
- recognised on the date on which we commit to purchase or sell an asset or liability
- included as non-current assets or liabilities, except for those that mature in less than 12 months from the reporting date, which are classified as current assets or liabilities.
(b) Utilisation of derivatives to manage risks
We enter into derivative transactions in accordance with policies approved by the Board to manage our exposure to market risks and volatility of financial outcomes that arise as part of our normal business operations. We do not speculatively trade in derivative financial instruments.
Hedging refers to the way in which we use financial instruments, primarily derivatives, to manage our exposure to financial risks. The gain or loss on the underlying item (the ‘hedged item’) is expected to move in the opposite direction to the gain or loss on the derivative (the ‘hedging instrument’), therefore offsetting our risk position. Hedge accounting allows the matching of the gains and losses on hedged items and associated hedging instruments in the same accounting period to minimise volatility in the income statement. In order to qualify for hedge accounting, prospective hedge effectiveness testing must meet all of the following criteria:
- an economic relationship exists between the hedged item and hedging instrument
- the effect of credit risk does not dominate the value changes resulting from the economic relationship
- the hedge ratio is the same as that resulting from actual amounts of hedged items and hedging instruments for risk management.
Our major exposure to interest rate risk and foreign currency risk arises from our long-term borrowings. We also have translation foreign currency risk associated with investments in foreign operations and transactional foreign currency exposures such as purchases in foreign currencies. These risks are discussed further in note 4.4.
To the extent permitted by Australian Accounting Standards, we formally designate and document our financial instruments by hedge type as follows:
Table F shows the carrying value and notional value of each component of our gross debt including derivative financial instruments categorised by hedge type.
(i) Fair value hedges
All changes in the fair value of the underlying item relating to the hedged risk are recognised in the income statement together with the changes in the fair value of derivatives. The net difference is recorded in the income statement as ineffectiveness. The carrying value of borrowings in effective fair value hedge relationships is adjusted for gains or losses attributable to the risk(s) being hedged.
Table G outlines the cumulative amount of fair value hedge adjustments that are included in the carrying amount of borrowings in the statement of financial position.
Table H shows the ineffectiveness recognised in the income statement. We have excluded foreign currency basis spreads from our designated fair value and cash flow hedge relationships.
(ii) Cash flow hedges
The portion of the gain or loss on the hedging instrument that is effective (offsets the movement on the hedged item) is recognised directly in the cash flow hedging reserve in equity and any ineffective portion is recognised as finance costs directly in the income statement.
Gains or losses deferred in the cash flow hedging reserve are subsequently:
- transferred to the income statement when the hedged transaction affects profit or loss (e.g. a forecast transaction occurs)
- included in the initial carrying amount when the hedged item is a non-financial asset or liability
- transferred immediately to the income statement if a forecast hedged transaction is no longer expected to occur.
Table I shows the hedge gains or losses transferred to and from the cash flow hedging reserve.
During the current and prior financial years, there was no material impact on profit or loss resulting from ineffectiveness of our cash flow hedges or from discontinuing hedge accounting for forecast transactions no longer expected to occur.
Table J shows when the cash flows are expected to occur with respect to items in cash flow hedges. These amounts are the undiscounted cash flows reported in Australian dollars and represent our foreign currency exposures at the reporting date.
Non-capital items will be recognised in the income statement in the same period in which the cash flows are expected to occur.
(iii) Derivatives not in a formal hedge relationship
Some derivatives may not qualify for hedge accounting or are specifically not designated as a hedge as natural offset achieves substantially the same accounting results. This includes forward foreign currency contracts that are used to economically hedge exchange rate fluctuations associated with trade creditors or other liability and asset balances denominated in a foreign currency.
4.3.4 Other hedge accounting policies
(a) Discontinuation of hedge accounting
Hedge accounting is discontinued when a hedging instrument expires, is sold, terminated, or no longer meets the criteria for hedge accounting. At that time, any cumulative gains or losses relating to cash flow hedges recognised in equity are initially retained in equity and subsequently recognised in the income statement as the previously hedged item affects profit or loss. For fair value hedges, the cumulative adjustment recorded against the carrying value of the hedged item at the date hedge accounting ceases is amortised to the income statement using the effective interest method.
(b) Embedded derivatives
Derivatives embedded in host contracts that are financial assets are not separated from financial asset hosts and a hybrid contract is classified in its entirety at either amortised cost or fair value. Derivatives embedded in other financial liabilities or other host contracts are treated as separate financial instruments when their risks and characteristics are not closely related to those of the host contracts and the host contracts are not measured at fair value through profit or loss.
4.4 Financial instruments and risk management (extract)
Our underlying business activities result in exposure to operational risks and a number of financial risks, including interest rate risk, foreign currency risk, credit risk and liquidity risk.
Our overall risk management program seeks to mitigate these risks in order to reduce volatility on our financial performance and to support the delivery of our financial targets. Financial risk management is carried out centrally by our treasury department under policies approved by the Board.
This note summarises how we manage these financial risks.
All our financial instruments are accounted for under AASB 9 (2013): ‘Financial instruments’.
4.4.1 Managing our interest rate risk
Interest rate risk arises from changes in market interest rates. Borrowings issued at fixed rates expose us to fair value interest rate risk. Variable rate borrowings give rise to cash flow interest rate risk, which is partially offset by cash and cash equivalents balances held at variable rates.
We manage interest rate risk on our net debt portfolio by:
- setting our target ratio of fixed interest debt to variable interest debt, as required by our debt management policy
- ensuring access to diverse sources of funding
- reducing risks of refinancing by establishing and managing our target maturity profiles entering into cross currency and interest rate swaps. Also refer to note 4.3.3.
Table C in note 4.3.2 sets out the carrying amount of borrowings. The use of cross currency and interest rate swaps allows us to manage the level of exposure our borrowings have to interest rate risks. Table A below shows our fixed to floating ratio based on the carrying value of our borrowings pre and post hedging.
For internal risk management purposes, we classify debt due to mature within 12 months as floating.
We have performed a sensitivity analysis based on the interest rate risk exposures of our financial instruments as at 30 June, showing the impact that a 10 per cent shift in interest rates would have on our profit after tax and on equity. In accordance with our policy to swap foreign currency borrowings into Australian dollars, interest rate sensitivity relates primarily to movements in Australian interest rates.
Table B shows the results of our sensitivity analysis.
A shift of 10 per cent has been selected as a reasonably possible change in interest rates based on the current level of both short-term and long-term interest rates. This is not a forecast or prediction of future market conditions.
The results of the sensitivity analysis are driven by the following main factors:
- any increase or decrease in interest rates will impact our net unhedged floating rate financial instruments and therefore will directly impact profit or loss
- changes in the fair value of derivatives which are part of effective cash flow hedge relationships are deferred in equity with no impact to profit or loss
- changes in the fair value of foreign currency basis spreads associated with our cross currency swaps are deferred in equity
- there is minimal net impact on profit or loss as a result of fair value movements on derivatives designated in effective fair value hedge relationships as there will be an offsetting adjustment to the underlying borrowing
- the analysis does not include the impact of any management action that might take place if a 10 per cent shift were to occur.
4.4.2 Managing our foreign currency risk
Foreign currency risk is our risk that the value of a financial commitment, forecast transaction, recognised asset or liability will fluctuate due to changes in foreign exchange rates. We issue debt offshore and operate internationally and hence we are exposed to foreign exchange risk from various currencies. However, our largest concentration of risk is attributable to the Euro, United States dollar and the Philippine peso.
This risk exposure arises primarily from:
- borrowings denominated in foreign currencies
- trade and other creditor balances denominated in foreign currencies
- firm commitments or highly probable forecast transactions for receipts and payments settled in foreign currencies or with prices dependent on foreign currencies
- net investments in foreign controlled entities (foreign operations).
We mitigate the foreign currency exposure on foreign currency denominated borrowings by:
- converting borrowings to Australian dollars using cross currency swaps
- holding borrowings to offset the translation of the net assets of a foreign controlled entity (we may also choose to hedge the foreign currency translation risk using derivatives). We have nil hedges in place for foreign currency translation risk associated with our investments in foreign operations (2017: nil).
Table C shows the carrying value of offshore borrowings by underlying currency. As at 30 June 2018, all offshore borrowings were swapped into Australian dollars (2017: all Australian dollars).
As at 30 June 2018, we also held $677 million (2017: $1,457 million) of commercial paper at carrying value, including $100 million denominated in United States dollar ($135 million Australian dollar equivalent). This was converted into Australian dollars using foreign exchange swaps.
We have some exposure to foreign currency risk from our operating (transactional) activities. We manage this risk by:
- hedging a proportion of the exposure of foreign exchange transaction risk arising from firm commitments or highly probable forecast transactions denominated in foreign currencies in accordance with our risk management policy. These transactions may be physically settled in a foreign currency or in Australian dollars but with direct reference to quoted currency rates in accordance with a contractual formula
- economically hedging a proportion of foreign currency risk associated with trade and other asset and liability balances
- economically hedging the risk associated with our wholly owned controlled entities (‘WOCE’) that may be exposed to transactions, both forecast and committed, in currencies other than their functional currency, in accordance with our overall risk management policy.
We hedge the above risks using forward foreign exchange contracts.
Table D summarises the impact of outstanding forward foreign exchange contracts that are hedging our transactional currency exposures.
(c) Natural offset
Our direct foreign exchange exposure arising from the impact of translation of the results of our foreign entities to Australian dollars is, in part, naturally offset at the Group level by foreign currency denominated operating and capital expenditure of business units, for which we do not have formal hedging in place.
We have performed a sensitivity analysis based on our foreign currency risk exposures existing at balance date. Table E shows the impact that a 10 per cent shift in applicable exchange rates would have on our profit after tax and on equity.
A shift of 10 per cent has been selected as a reasonably possible change taking into account the current level of exchange rates and the volatility observed both on a historical basis and on market expectations of future movements. This is not a forecast or prediction of future market conditions.
We are exposed to equity impacts from foreign currency movements associated with our offshore investments and our derivatives in cash flow hedges of offshore borrowings. Foreign currency risk is spread over a number of currencies. We have disclosed the sensitivity analysis on a total portfolio basis and not separately by currency.
The translation of our foreign entities’ results into the Group’s presentation currency has not been included in the above sensitivity analysis as this represents translation risk rather than transaction risk.
Any unhedged foreign exchange positions associated with our transactional exposures will directly affect profit or loss as a result of foreign currency movements.
There is no significant impact on profit or loss from foreign currency movements associated with our borrowings portfolio in effective fair value or cash flow hedges as an offsetting entry will be recognised on the associated hedging instrument.
The analysis does not include the impact of any management action that might take place if these events occurred.
4.2 Equity (extract)
4.2.2 Reserves (extract)
Table B details our reserve balances.