Annual report and financial statement 2009 - United Utilities

Market riskMarket risk is the risk that movements in market rates, including foreign exchange rates, interest rates and inflation will affect thegroup’s results. The management of market risk is undertaken with risk limits approved by the board.The group borrows in the major global debt markets in a range of currencies at fixed and floating rates of interest, using derivatives,where appropriate, to generate the desired effective currency profile and interest basis.The group uses a variety of financial instruments, including derivatives, when raising finance for its operations in order to manage anyexposure arising from funding activity.Interest rate riskThe group’s fixed rate borrowings are exposed to a risk of change in their fair value due to changes in interest rates. The group’s floatingrate borrowings are exposed to a risk of change in cashflows due to changes in interest rates. The group uses interest rate swap contractsand financial futures to hedge these exposures. Investments in equity securities and short-term receivables and payables are notexposed to interest rate risk.The group’s policy is to structure debt in a way that best matches the cashflows generated by its underlying assets. Revenues from theregulated business are determined by the real cost of capital fixed by the regulator for each five-year regulatory pricing period. Thepreferred form of debt, therefore, is sterling index-linked debt which is fixed in real terms also. Where conventional long-term debt israised in a fixed rate form, the group will swap to floating rate, at inception over the life of the liability, through the use of interest rateswaps.The group, using a second layer of interest rate swaps, fixes in nominal terms a material proportion of the floating cost of debt for theduration of the five-year regulatory pricing period to match better the fixed nature of the group’s revenue stream.The group assesses any residual floating rate exposure with regard to net debt, after the effect of derivative contracts, to determinewhether to hedge using futures contracts.Sensitivity analysisAs required by IFRS 7 ‘Financial Instruments: Disclosures’, the sensitivity analysis has been prepared on the basis of the amount of netdebt and the interest rate hedge positions in place as at 31 March 2009 and 31 March 2008, respectively. As a result, this analysisrelates to the position at the balance sheet date and is not indicative of the years then ended, as these factors would have variedthroughout the year.The following assumptions were made in calculating the interest sensitivity analysis:• all fair value hedge relationships, including associated swaps classified as held for trading, are fully effective and therefore there is nobalance sheet sensitivity to interest rates with regard to these designated debt and swaps instruments;• all borrowings designated at fair value through profit or loss are effectively hedged by associated swaps and therefore there is no balancesheet sensitivity to interest rates (excluding the effect of accrued interest) with regard to the associated debt and swap instruments;• the main balance sheet sensitivity to interest rates (excluding the effect of accrued interest) is in relation to the regulatory swapswhich swap the majority of the floating rate exposure to fixed rate for the five-year regulatory period;• the sensitivity of net finance expense to movements in interest rates is calculated on net floating rate exposures on debt and derivatives;and on deposits. The floating leg of a swap or any floating rate debt is treated as not having any interest rate already set, therefore achange in interest rates will have a full 12-month impact on interest;• the standard requires that a change in the relevant risk variable be applied to the risk exposures in existence at the balance sheet date,therefore deposits at the balance sheet date are taken and any debt or swaps maturing during the year are disregarded;• index-linked debt is carried at amortised cost and therefore the balance sheet is not exposed to movements in interest rates. It isassumed that inflation is held constant;• financial futures contracts entered into by the group to further manage the floating interest rate exposure are excluded from this analysis;• the analysis excludes the impact of movements in market variables on the carrying value of pensions and other post-retirement obligations;• management has assessed 100bp as a reasonably possible movement in UK interest rates; and• all other factors are held constant.Financial statementsunitedutilities.com 75