20 Financial Instruments

Primary Financial Instruments

The interest expenses contain €10.4 million (2007: €13.7 million) from financial liabilities recognized at amortized cost. No profit was generated by the redemption of those financial instruments. Loans and receivables or financial liabilities at amortized cost in a foreign currency produced net profit of €126.0 million (2007: €24.5 million) and net loss of €–127.1 million (2007: €–43.9 million). These are presented under other operating income and expenses. Net profits from available-for-sale financial assets originate mainly from investment income. In addition, other operating income and expenses include €9.5 million (2007: €–3.4 million) from the currency translation of cash and cash equivalents. Derivative financial instruments of which the market values changes are recognized in profit or loss led to net earnings of €15.8 million (2007: €32.7 million). €32.9 million (2007: €23.2 million) of this sum relates to derivatives from hedge accounting which are listed under other operating income and expenses. Financial assets and liabilities did not undergo any major impairments. Neither in the year under review nor in the previous year were there any reclassifications of financial assets between those recognized at amortized cost and those recognized at market value or vice versa.

Derivative Financial Instruments

WACKER is exposed to exchange rate, interest rate, and raw materials price risks in the normal course of its business. The raw material price risks that it hedges against result principally from precious metals (platinum, gold, palladium) which are used as catalysts or for other purposes in the production process.

In those cases where WACKER hedges against these risks, it uses derivative financial instruments, in particular currency option and forward exchange contracts, and foreign exchange swaps. Derivatives are used only if they are backed by positions, cash deposits and funding, or scheduled transactions arising from operations (underlying transaction). The scheduled transactions also include anticipated, but not yet invoiced sales in foreign currencies.

Foreign exchange hedging is carried out mainly for the US dollar (US$), the Japanese yen, and the Singapore dollar. In the case of foreign exchange hedging in the financing area, the maturities of the receivables and/or liabilities are taken into account. Interest rate hedging is carried out primarily for the euro and the US dollar, with the maturities of the underlying transactions being the most important factor.

Operational hedging in the foreign exchange area relates to the receivables and liabilities already recognized and generally encompasses time horizons of between three and four months. The time horizon of strategic hedging is between four and a maximum of 27 months. The hedged cash flows influence the income statement at the time when sales are realized. The cash inflows are usually recorded shortly afterwards, depending on the payment deadline. As well as receivables from and liabilities to third parties, intercompany financial receivables and liabilities are hedged.

WACKER is exposed to a credit risk where derivatives have a positive market value and counterparties to a contract are unable to render their performance. To limit the risk of default, transactions are conducted only within defined limits and with partners of extremely high credit standing. To make efficient risk management possible, the market risks within the Group are controlled centrally. The conclusion and handling of transactions comply with internal guidelines and undergo monitoring procedures that take account of the division of functions.

The market values refer to the maturity repurchase values (redemption values) of the financial derivatives as of the balance sheet date. They are calculated on the basis of quoted prices or with the help of standard calculation methods.

In the valuation of forward contracts WACKER applies consistently with the previous year the zero-coupon method. With the global eonomic crisis impacting financial markets other valuation models (e.g. the par method) could result in different fair values and thus increasing or decreasing net income at the time of liquidation. WACKER though does not intend to realize a derivative before maturity according to the hedging relationship. In principle, all valuation models are subject to greater risk stemming from the current financial crisis. Therefore one cannot rely on the existence of a market where such fair values derived from valuation models have any relevance.

The derivatives are measured at their market values, irrespective of their stated purpose. They are reported in the balance sheet under other assets and/or other liabilities. Where permissible, we apply hedge accounting for the strategic hedging of currency exchange risks from future foreign exchange positions. In such cases, the changes in the market value of foreign exchange contracts and the changes in the intrinsic value of currency options are recognized under equity with no effect on net income until the underlying transaction takes place. The changes in the time values of the currency options are posted to the income statement. In some cases there are embedded derivates. Those are measured at fair value if derivable. Otherwise they are measured at amortized cost. Embedded derivatives are also reported under other assets or other libabilities, respectively.

Depending on the nature of the underlying transaction, they are presented in the income statement either under other operating income and/or expenses or, if financial liabilities are being hedged, under the interest result.

The increase in the nominal values of foreign exchange derivatives results mainly from two facts: a higher hedging ratio and an extension in the hedging horizon. The currency option transactions that were still unsettled at the end of 2008 will fall due in the course of the subsequent fiscal years (2009 – 2010).

The currency option volumes as of year-end 2008 were US$30 million (puts) and ¥3.9 billion (puts). In addition, there are forward exchange contracts amounting to US$1.43 billion and ¥32.8 billion.

A cross-currency swap was used as a foreign exchange hedge for an existing loan of US$70 million. It matures in 2010.

Information on the Type and Extent of Risks

The risks connected with the procurement, financing, and selling of WACKER’s products and services are described in detail in the management report. The Executive Board regularly receives analyses on the extent of those risks. The analyses focus in particular on the potential impact of raw material price risks, foreign exchange risks, and interest rate risks on EBITDA and net interest income.

Foreign Exchange Risks

The evaluation of the risk potential of hedging is based on the most significant US-dollar income and expenditure. US-dollar income is defined as all sales invoiced in US dollars, while the expenditure in question is defined as all US-dollar purchases and all site-related costs incurred in US dollars. In addition to the direct US-dollar income and expenditure, the evaluation of potential risks includes the indirect US-dollar impact of the main raw materials (methanol and natural gas). An increase of 1 US-cent in the exchange rate of the euro against the US-dollar would cause EBITDA to fall by €5.3 million (2007: €6.6 million). In this number hedges of the US$ exposure are not implied. Increases in the euro exchange rate against the SGD and JPY, on the other hand, have only a minor impact.

Interest Rate Risk

The interest rate risk results mainly from financial debt and interest-bearing assets. Each year, the Executive Board determines the mixture of fixed and variable-interest net financial debt. The interest rate risks are measured on the basis of market-value or cashflow sensitivity, depending on whether the instrument in question (financial liabilities, investments, interest rate derivatives) has a fixed or variable interest rate. Financial liabilities and fixed-interest investments are measured at net book value and are, therefore, in accordance with IFRS 7, not subject to any risk of changes in interest rates. Hedge accounting is not used for any of the interest rate derivatives. Changes in market interest rates have an impact on the net interest income generated by variable-interest financial instruments and are, therefore, included in the calculation of earnings-related sensitivity. Changes in the market interest rates of interest rate derivatives affect the financial result and are, therefore, included in any earnings-related sensitivity analysis. If current interest rates had been 100 base points higher (lower) on average, net interest income would have been €2.1 million (2007: €0.8 million) higher (lower).

Liquidity Risk

The liquidity risk means that WACKER may not be able to meet its financial obligations sufficiently. To limit this risk, WACKER keeps liquid reserves in the form of current investments and credit lines. WACKER has concluded agreements with a number of banks for long-term syndicated loans and bilateral loan agreements. The aggregate volume of these loans is significantly higher than the planned financial liabilities.

Raw Materials Price Risk

Potential combinations of factors in the natural gas or ethylene segments make it impossible to exclude the risk that the company’s supply of raw materials might be insufficient. Ethylene-related risks, however, will be reduced substantially by the EPS pipeline which is currently under construction in Germany. In general, potential increases in raw materials prices pose a risk to results. An increase of 1% would lead to a drop of €9.1 million (2007: €6.8 million) in EBITDA.