Financial risks

For this risk category, the likelihood of occurrence is classified as high (previous year: medium) and the potential extent of damage is clas¬sified as medium (previous year: medium).

The most significant risks from the QRP arise mainly from exchange rate risks and the deterioration of financing opportunities.

Strategies for hedging financial risks and the resulting risks arising from financial instruments

We operate across numerous jurisdictions around the world, conducting business in multiple currencies and as a result, are exposed to financial risks that may arise from changes in interest rates, exchange rates, raw material prices, or share and fund price – as well as from unforeseeable events such as a sudden outbreak of geopolitical or geoeconomic tensions and conflicts or the intensification of existing tensions and conflicts. We continuously monitor these financial and liquidity risks and mitigate them using non-derivative and derivative financial instruments. These give rise to counterparty risks, which we mitigate using our counterparty risk management.

Interest rate risk is the possibility of losses in business operations or financial transactions due to fluctuations in market interest rates. This risk arises when there are differences in interest rates between assets and liabilities within a portfolio or on the balance sheet. For example, variable interest rate exposures on the liability side have arisen due to the issuance of a floating rate bond by the Automotive Division in the past, which was intentionally not hedged with a derivative instrument. We hedge interest rate risk – where appropriate in combination with currency risk – and risks arising from fluctuations in the value of financial instruments by means of interest rate swaps, cross-currency interest rate swaps and other interest rate contracts with generally matching amounts and maturities. The principle of matching amounts and maturities applies to financing arrangements within the Volkswagen Group in the Automotive Division. In the Financial Services Division, the risk of changes in the interest rate is managed on the basis of limits using interest rate derivatives as part of the defined risk strategy.

We are exposed to the effects of changes in the exchange rates especially against the euro – of several currencies that play a role in our worldwide operations. Such currencies include but are not limited to, the Australian dollar, Brazilian real, British pound sterling, Canadian dollar, Chinese renminbi, Czech koruna, Hong Kong dollar, Hungarian forint, Indian rupee, Japanese yen, Mexican peso, Norwegian krone, Polish zloty, Singapore dollar, South African rand, South Korean won, Swedish krona, Swiss franc, Taiwan dollar and US dollar. As a result, we are also exposed to financial risks that might arise from changes in interest rates. Foreign currency risk is reduced in particular through natural hedging, i.e. by adapting our production capacity at our locations around the world, establishing new production facilities in the most important currency regions and also procuring a large percentage of components locally. We partially hedge the residual exchange rate risk using hedging instruments. These mainly comprise currency forwards and currency options. We use these transactions to limit the exchange rate risk associated with forecasted cash flows from operating activities, intragroup financing and liquidity positions in currencies other than the respective functional currency, for example as a result of restrictions on capital movements. The currency forwards and currency options can have a term of up to ten years, Volkswagen applies a layered hedging approach in this regard. We use these to hedge our principal foreign currency risks, mostly against the euro and primarily against the currencies already mentioned above.

We have used and are expected to continue to use hedging instruments in the future to manage commodity and energy price fluctuations. There are risks in hedging raw materials with regard to raw material availability and price trends. We manage commodity and energy price risks by entering into forward contracts and swaps. We have hedged aluminum, copper and lead needs for up to six years and cobalt and lithium for less than three years. Nickel is hedged strategically for up to ten years, mainly covering the next six years. The hedge ratios decrease with longer maturities. We also have contracts in place to hedge electricity and gas prices. The hedging periods for platinum, palladium and rhodium are typically limited to a maximum of three years. In the case of certain commodities, this may include adjustments in physical inventories. Transactions involving emission allowances have also been conducted to hedge the prices associated with CO₂ emissions that are expected to exceed free allocations under the European Union Emissions Trading System (EU ETS) for the coming years.

We invest surplus liquidity into special funds which are subject to equity price risks and fund price risks. These risks are managed by diversifying investments and adhering to the limits specified in the relevant investment guidelines. Hedging measures are executed, when required by market conditions.

Channeling excess liquidity into investments and entering into derivatives contracts gives rise to counterparty risk. We counter this risk through our counterparty risk management, which we describe in more detail in the section entitled “Principles and Goals of Financial Management” in the “Results of Operations, Financial Position and Net Assets” chapter. The financial instruments held for hedging purposes give rise to counterparty risks, and also to balance sheet risks, which we limit using hedge accounting.

In addition, financial instruments used in risk hedging strategies may result in losses if the hedging exchange rates are less favorable than the rates achievable on the market at the maturity of the financial instrument.

Our hedging policy, the hedging rules, the default and liquidity risks and the quantification of the hedging transactions mentioned, risks that arise in connection with trade receivables, and risks arising from financial services are explained in the notes to the consolidated financial statements. We also disclose information on market risk within the meaning of IFRS 7 in the notes.

Liquidity risk

The Volkswagen Group’s ability to meet its financing requirements depends on maintaining sufficient liquidity. There is an inherent risk that existing capital needs may not be met if the Company cannot obtain funding or if financing is only available under unfavorable conditions.

The Automotive Division and the Financial Services Division generally pursue independent refinancing strategies, though both encounter comparable refinancing risks. Within the Automotive Division, liquidity is maintained primarily through retained earnings, utilization of credit lines and the issuance of financial instruments in the money and capital markets. For the Financial Services Division, capital demands are predominantly addressed by sourcing funds from both domestic and international markets – this includes securitizing receivables, issuing unsecured bonds and attracting customer deposits via direct banking operations.

Our investment activities are also financed through loans sourced from national development banks such as Kreditanstalt für Wiederaufbau (KfW) and Banco Nacional de Desenvolvimento Econômico e Social (BNDES), as well as from supranational development banks.

In addition to committed credit lines, our diversified refinancing framework is further supported by uncommitted credit lines provided by commercial banks.

Our financing opportunities might be adversely affected by a deterioration in financial and general market conditions – also resulting from a sudden outbreak of geopolitical tensions and conflicts or an intensification of existing ones –, a weakening of our credit profile and outlook as well as by a rating downgrade or withdrawal or increasing relevance of ESG ratings to investors. In these cases, the demand from capital market participants for securities issued by us may decrease, which could adversely impact the rates of interest we have to pay and may result in lower capacity to access the capital markets.

If financial and general market conditions deteriorate or credit spreads and/or the general level of interest rates increase, this would result in higher interest expenses. Unlimited exposure to fluctuations in interest rates could result in materially higher financing costs, which, in turn, would adversely affect our profitability.

Credit risks and opportunities and counterparty risk in the financial services business

We are exposed to the risk that the credit quality of our retail customers and business partners such as dealers and other corporate customers may deteriorate and in the worst case that they may default.

Credit risks and opportunities

Credit risk describes the risk of losses arising from defaults in customer transactions, specifically due to the default of the borrower or lessee. The default is caused by the insolvency or unwillingness of the borrower or lessee to pay. This includes the fact that the contractual partner does not make interest and principal payments on time or in full.

The aim of a systematic credit risk monitoring system is to identify the potential insolvency of a borrower or lessee at an early stage, to take appropriate account of the facts in the loss allowance calculation and, if possible, to prevent a potential default.

The consequence of a default could be a loss of entrepreneurial assets. If, for example, an economic downturn leads to increased insolvencies or unwillingness of borrowers or lessees to make payments, higher loss allowances and losses must be recognized.

An essential basis for credit decisions is the credit assessment of the borrowers. Rating/scoring procedures are used to provide an objective basis for decision-making of granting a credit or leasing.

Credit risks are managed and monitored on the basis of defined guidelines and processes. All loans are monitored with regard to the economic circumstances of the borrower or lessee, the meeting of contractual obligations, external or internal conditions defined in the credit approval process, existing collateral and adherence to any granted limits. For this purpose the commitments – according to their risk content – are managed in an appropriate monitoring level (normal, intensified and problem loan management). Furthermore, the management of the credit risk is made by credit approval or reporting limits and defined credit approval competencies, which are determined individually for each branch or subsidiary.

An opportunity from credit risks may arise if the losses from the credit and leasing business are lower than the previously expected losses and the corresponding risk provision recognized on this basis. Particularly in countries where an increased need for risk provision has been identified due to the uncertain economic situation, a stabilization of the economic situation and the associated improvement in the creditworthiness of borrowers may result in a chance that the losses realized will be lower than expected.

Counterparty risk/issuer risk

We are exposed to the risk that the creditworthiness of our contractual counterparties in the money and capital markets may deteriorate. In our Automotive and Financial Services Divisions, we maintain extensive business relationships with banks and financial institutions, in particular, to control liquidity through call money and fixed term deposits as well as to hedge against such risks as currency exchange rate, interest rate and commodity price risks using derivatives. In this context, we are exposed to default risks with respect to the repayment of and interest on the deposits and the fulfillment of obligations under such derivatives. It might become necessary to sell financial instruments prior to or at maturity – for example, due to concerns about the creditworthiness or insolvency of the issuer – which might result in losses. Under certain circumstances, this could even lead to a complete default on the receivable by the underlying issuer.

If the macroeconomic environment were to deteriorate in the future, the risks described above could rise and require higher risk provisions.

Residual value risks and opportunities

A residual value risk arises if the forecasted market value upon disposal of the leased or financed asset at the end of the contract is lower than the residual value calculated at the time the contract was concluded, or if the sales proceeds are lower than the book value of the vehicle in the event of early termination of the contract due to contractual termination options. On the other hand, there is a chance that the sale will generate more than the calculated residual value or book value.

A decrease in the residual values or the sales proceeds of leased vehicles or vehicles financed with a product with balloon rate and return option could have an adverse effect on our business.

As a lessor under leasing contracts, including financing contracts with a balloon rate and return option for the customer, the Financial Services Division generally bears the risk that the market value of vehicles sold at the end of the term may be lower than the contracted residual value at the time the contract was entered into (so-called residual value risk). The Financial Services Division takes such differences into account in establishing provisions for the existing portfolio and in its determination of the contractual residual values for new business.

Volkswagen distinguishes between direct and indirect residual value risks. If the Financial Services Division carries the residual value risk, it is referred to as a direct residual value risk. The residual value risk is indirect when that risk has been transferred to a third party (such as a dealer) based on a residual value guarantee. The Financial Services Division frequently enters into agreements that require dealers to repurchase vehicles, so dealers, as residual value guarantors, would bear the residual value risk. In these cases, there is a counterparty default risk with regard to the residual value guarantor. If a residual value guarantor defaults, the residual value risk pass onto the Volkswagen Group.

Residual value risk can be affected by various external factors. Changes in consumer confidence and preferences, economic conditions, government policies, exchange rates and perceptions of vehicle quality, safety, or reliability can all increase this risk. Among other things, Volkswagen was required to increase existing loss provisioning for residual value risks in the past. It cannot be ruled out that a similar scenario due to renewed deterioration of the macroeconomic environment could occur in the future. The evolution of e-mobility also plays a role; advancements in battery technology may increase residual value risks for existing electric vehicles as demand for outdated technologies wanes. Equally, growing sales of electric cars due to shifting consumer behavior could negatively affect the residual values of conventional combustion vehicles. On the other hand, component shortages, rising costs of raw materials, energy and logistics, as well as procurement and delivery challenges, might lead to a decrease in new vehicle production or sales, and conversely an increased in used car values, potentially reducing our residual value risk.

Estimates of provisions for residual value risks might be less than the amounts actually required to be paid due to miscalculations of initial residual value forecasts or changes in market or regulatory conditions.

Management of the residual value risk is based on a defined control cycle, that ensures risks are fully assessed, monitored, responded to and communicated. This process structure enables us to manage residual risks professionally and also to systematically improve and enhance the way we handle residual value risks.

As part of risk management procedures, the adequacy of the provision for risk and the potential residual value risk are regularly reviewed in respect of direct residual value risk. The preparation of the risk management report includes a review of adequacy wherein the level of existing direct residual value risk is compared to the level of the provisions recognized for risks. Based on the resulting potential residual value risk, various measures are initiated as part of an active risk management approach. With regard to new business, the residual value recommendation must take into account current market circumstances and factors that might have an influence in future.

Dependency of the Financial Services Division

Volkswagen’s Financial Services Division is dependent on the Volkswagen Group’s sales, and any risk that negatively influences the vehicle delivery of the Volkswagen Group might have adverse effects on the business of the Financial Services Division.

Volkswagen’s Financial Services Division business model is mainly the sales support of products of the Automotive Division. Thus, the financial success of the Financial Services Division depends largely on the success of the Automotive Division. The development of vehicle deliveries to customers of the Volkswagen Group is crucial and material to the generation of new contracts for the Financial Services Division.