Cadbury Schweppes plc

Introduction

Cadbury Schweppes plc is a confectionery and non-alcoholic beverage company.
The Company’s products include brands, such as such as Cadbury, Schweppes, Halls,
Trident, Dr Pepper, Snapple, Trebor, Dentyne, Bubblicious and Bassett. Cadbury
Schweppes operates in five segments: Britain, Ireland, Middle East and Africa (BIMA),
Europe, Americas Confectionery, Asia Pacific and Americas Beverages. Americas
Confectionery, BIMA and Europe produce and distribute confectionery products in their
respective geographical markets. (Google Finance, 2008). The Asia Pacific segment
produces and distributes confectionery and beverages products in the Asia Pacific region.
Americas Beverages market, produce and distribute branded soft drinks in North
America. During the year ended December 31, 2007, the Company acquired
confectionery businesses in Romania (Kandia-Excelent), Japan (Sansei Foods) and
Turkey (Intergum). (Google Finance, 2008)

Rio Tinto plc and Rio Tinto Limited operate as one business organization (Rio
Tinto). Rio Tinto is an international mining company. The Company’s business is
finding, mining and processing mineral resources. (Google Finance, 2008). Its major
products are aluminum, copper, diamonds, coal, uranium, gold, industrial minerals
(borax, titanium dioxide, salt, talc), and iron ore. Businesses include open pit and
underground mines, mills, refineries and smelters, as well as a number of research and
service facilities. On October 23, 2007, Rio Tinto acquired Alcan Inc. (Google Finance,
2008)

Both companies have operations that span across national boundaries, as well as
long term liabilities. This indicates that they face both exchange rate and interest rate
risks. This paper is aimed at looking at the different exchange rate and interest rate risks
that these companies face, the risk management policies, the instruments used in hedging
these risks and the implications of these risk and risk management strategies to investors.
Having said this, the paper will now go on to discuss the different types of risks.

Currency Risk

Currency exposure refers to the risk of financial loss that a company suffers as a result of
changes or fluctuations in interest rates. The financial loss may come as a result of
changes in the value of cash flows or as a result of changes in the recorded value of assets
and liabilities of the company. There are three main types of exposure that a company
may face. These include (Shapiro, 2003):

• Translation exposure;
• Transaction exposure; and
• Economic Exposure.

Translation exposure is the exposure a firm faces because of its assets and liabilities that
are denominated in foreign currency. It is the exposure that is basically faced by
multinational companies that have subsidiaries in many other countries. Translation
exposure has no major effect on value of the firm because it affects only balance sheet
and income statement items that are denominated in a foreign currency.

Transaction exposure is the exposure a firm faces as a result of its contractual obligations
that are denominated in a foreign currency. It represents the exposure a company faces as
a result of its contractual obligations that have already been booked but that would be
settled at a future date (Shapiro, 2003). These include for example, repayment of loans
denominated in overseas currencies, purchases from overseas companies and dividends
from overseas subsidiaries.

Economic exposure otherwise referred to as operating exposure is a measure of the
changes in the present value of the firm which occurs as a result of fluctuations in
exchange rates. Economic exposure encompasses transaction exposure but it is far more
extensive in that it includes the future operations and transactions of the firm that are yet
to be booked. For example, a company that sources inputs from another country faces
economic exposure given that prices of inputs may increase in future if the foreign
currency happens to appreciate against the domestic currency. This is so because if the
foreign currency appreciates against the domestic currency in future, it will have to pay
more in terms of the domestic currency for the same quantity of inputs than it currently
pays at the current exchange rate.

Currency Risk Faced by Cadbury Schweppes

Cadbury Schweppes faces two main types of risks. These include transaction exposure
and translation exposure. The company faces translation exposure because it has
subsidiaries in many different countries. Its main translation exposure comes as a result
of its presence in the USA. (Cadbury Schweppes Annual Report, 2007). For example, the
company has both floating rate and fixed rate debt denominated in foreign currency.
Appendix 1 shows the impact on the income statement of the company of a 10%
weakening of the GBP against other currencies. It can be observed from appendix 1 that
if the GBP depreciates against other currencies by 10%, its cash and cash equivalents will
increase by £36million, borrowings will increase by £351million and currency exchange
rate contracts (including embedded derivatives will increase by £2million. The company
also has debt denominated in foreign currency. For example, as at 2007, the company had
bank loans denominated in foreign currency to the tune of £770million for floating rate
debt. It also had floating rate debt in foreign currency including 4.9% Canadian dollar
(CAD) notes due in 2008 to the tune of £142million, it had 3.875 US dollar (USD) notes
to the tune of £502million due in 2008. It had 4.25% Euro (EUR) notes to the tune of
£440million due in 2009 as well as 5.125 USD notes to the tune of £501million due in
2013. All these debt contractual obligations in foreign currency represent part of the
transaction exposure faced by Cadbury Schweppes since fluctuations in the values of the
foreign currency may affect the cash flows of interest and principal repayments in future
periods.

Currency Risk Faced by Rio Tinto Plc.

Rio Tinto Plc has activities that span the world especially in Australia, North America,
South Africa, Asia, Europe and Africa. Consequently, it faces significant exposure to
currency risk. Like Cadbury Schweppes, Rio Tinto Plc is basically affected by all three
types of foreign exchange exposure: translation exposure, transaction exposure and
economic exposure. As concerns translation exposure, the company has a number of
subsidiaries and must translate the various income statement, balance sheet and cash flow
items to the US dollar on each balance sheet date. These translations result to foreign
currency exchange gains and losses. Translation exposure is a measure of the foreign
exchange losses when it is translating its foreign currency items into the US dollar. In
addition to the translation exposure that results from translating financial statement items
of subsidiaries, Rio Tinto also faces translation exposure with respect to its other foreign
currency-denominated assets and liabilities. Rio Tinto faces transaction exposure in that it
has contracts with cash flows that are denominated in foreign currencies. Its transaction
exposure comes as a result of the fact that these changes in these exchange rates may
result to lower cash inflows from receivables that will be settled at a future date, as well
as higher cash outflows for financial obligations such as interest and principal repayments
that will be settled at a future date. Rio Tinto Plc faces economic or operating exposure in
that some of its inputs are sourced from different parts of the world. Movements in the
home currency value of the currencies of these countries may greatly affect Rio Tinto’s
costs of inputs. The main currencies that affect Rio Tinto in terms of translation,
transaction and economic exposure are the Australian dollar, The US Dollar and the
Euro. (Rio Tinto Plc Annual Report, 2007). Appendix 3 shows the average exchange rate
between the US dollar and the major currencies that Rio Tinto interacts with. These
include, the Australian dollar, the Canadian dollar, the Euro, the New Zealand Dollar, the
South African rand and the UK pound Sterling. The appendix also shows the effect on net
and underlying earnings of a change in the average exchange rate of any of these
currencies and the US dollar. It can be observed that a 10% change in the average
Australian dollar/US dollar exchange rates results into a US$494million increase or
decrease in net and underlying earnings; A 10 change in the US dollar/Canadian dollar
exchange rate results into a US$203million increase or decrease in net and underlying
earnings; a US$65million loss is anticipated for a 10% change in the average exchange
rate between the US dollar and the Euro; a 10% change in the average US$/South African
rand exchange rate results into a US$55million increase or decrease in net and underlying
earnings; whereas a 10% change in the UK pound sterling/ US$ exchange rate results into
a US$24million increase or decrease in net and underlying earnings. (Rio Tinto Plc
Annual Report, 2007). Minimal changes are observed for a 10% change in the US$
/Chilean peso and the US$ /New Zealand dollar average exchange rates, that is,
US$12million and US$17million respectively.

Interest Rate Risks

Interest rate risks is the risk that the value of an investment will change as a result of
changes in the absolute level of interest rates, the spread between two rates, the shape of
the yield curve or in any other interest rate relationship. Bond prices are more affected by
interest rate risk than other securities such as stocks. Interest rates are inversely related to
the value of a bond, that is, when interest rates rise, the value of the bond falls and vice
versa. This is because as the interest rates increase, the opportunity cost of holding a bond
decreases since investors are able to realize greater yields by switching to other
investments that reflect the higher interest rate. For example consider a bond that pays
5% interest. This bond will be worth more if interest rates fall, since the bondholder will
be receiving fixed rate of return relative to the market, that offers a lower rate of return as
a result of the fall in interest rates.

Interest rate risk measures the sensitivity of a firm’s cash flows, profit and firm
value to interest rate fluctuations. In addition to the interest risk that a company might
face as a result of changes in its cash flows, profit and firm value. Buckley (1996)
identifies two other types of interest rate risk, which include basis risk and Gap risk.

If interest rates are determined on a different basis for assets and liabilities then a
firm having loans and debts will face basis risk. A company faces basis risk when the
interest rates on its loans and debts are determined using different basis. (Buckley, 1996)
Assume for example that Kaufman & Connelly Plc issues a fixed rate bond to fund its
financing needs and at the same time gives out a loan to another party at a floating
interest rate. Her interest payments will therefore be fixed while interest receipts will be
variable and will depend on prevailing rates. She will therefore be facing basis risk since
her interest expenses and revenues will be determined on different basis.

A company faces gap risk when it has both fixed rate liabilities and assets. When
fixed rate liabilities exceed fixed rate assets then there is positive Gap, with a positive gap
a rise in short term rates increases margins while declining rates decrease margins. On the
contrary if fixed rate liabilities are less than fixed rate assets, then there is negative gap.
In this case a rise in short-term rates decreases margins while a decrease increases
margins.(Buckley, 1996).

Interest rate risk faced by Cadbury Schweppes

Cadbury Scwheppes has debt obligations. It has both fixed and floating rate debt
which entail interest rate risk. Fixed rate debt entails interest rate risk in that when
interest rates fall, the company will continue paying interest rates at the higher rates.
Floating rate debt does not carry high interest rate risk as the rates will be adjusted as
interest rates change.

Interest Rate Risks Faced by Rio Tinto.

Like Cadbury Schweppes, Rio Tinto Plc has both floating rate and fixed rate debt.
It faces interest rate risk with respect to the fixed rate debt in that changes in interest rates
may affect the cash flows with respect to interest payments. For example, it will have to
continue paying higher interest rates on its fixed rate debt when irrespective of a fall in
market interest rates.

How Cadbury Schweppes and Rio Tinto Manage Their Currency and Interest
Rate Risks.

Cadbury Schweppes’ Currency Risk Management Policies.

Cadbury Schweppes does not hedge against translation exposure because the benefits
from hedging this exposure are temporal in nature. It seeks to establish an equal and
opposite relationship between the borrowing structure and the trading cash flows that is
used in servicing interest and principal repayments. It also seeks to maintain broadly
similar fixed charge cover ratios for each currency bloc and ensures that the ratio for any
currency does not go below by two times in any calendar year. (Cadbury Schweppes
Annual Report and Accounts, 2007). The group achieves this by borrowing in different
currencies, as well as through the use of hedging instruments such as swaps. The group
manages is transaction exposure which arises from its international trade by entering
forward contracts for all forecasted receipts and payments for as far ahead as the pricing
structures are committed. The forward forex market therefore plays a significant role in
the exchange risk management structure of the group. Despite foreign exchange
restrictions and controls, which affect certain subsidiaries remission of funds to the
headquarters, the group believes that these restrictions do not have a material impact on
its operations as a whole. (Cadbury Schweppes Annual Report and Accounts, 2007).

Rio Tinto’s Currency Risk Management Policies.

Since the US dollar dominates most of the affairs of the group, its consolidated financial
results are presented in US dollar terms. Most of the borrowings as well as surplus cash is
denominated in US dollars. The group also maintains a major portion of its cash in other
currencies most notably the Australian dollar, the Euro and the Canadian dollar since it
also has major operations in Australia, Canada and Europe. Most of its operations are
financed in US dollars directly or through the use of cross currency interest rate swaps.
Most subsidiaries maintain the US dollar as the functional currency. This helps to reduce
the translation exposure of the group as the need for translation of the subsidiary’s
financial statements to US dollars is eliminated completely. Rio Tinto does not believe
that active currency hedging of transactions will result in long term benefits to its
shareholders. Currency hedging measures and therefore carried out only in specific
circumstances and are subject to strict limits laid down by the Rio Tinto board. The group
typically hedges capital expenditures and other significant financial items such as tax and
dividends.

Cadbury Schweppes’ Interest Rate Risk Management Policies.

The company maintains both fixed and floating rate debt. It manages its interest rate
exposure by using interest rate swaps, cross currency interest rate swaps, forward rate
agreements and interest rate caps. It combines floating and fixed rate debts to enable it
reduce the impact of an upward change in interest rates while maintaining benefits if
interest rates happen to fall. The treasury risk management policy maintains minimum
and maximum levels of the total net debt and preferred stock permitted to be at fixed or
capped rates in various time bands, which range from 50% to 100% for the period up to
six months, to 0% to 30% when the period is over five years. (Cadbury Schweppes
Annual Report and Accounts, 2007). In setting the percentages, reference is made to the
current average level of net debt.

Rio Tinto Plc’s Interest Rate Risk Management Policies.

Rio Tinto Plc maintains an interest rate risk management policy where it borrows
and invests at floating interest rates. In doing so, reference is made to historical
correlation between interest rates and commodity prices. Under certain circumstances, the
group considers fixed rate borrowing as well. Interest rate risk is mitigated through the
use of cross currency interest rate swaps which enable it convert fixed rate foreign
currency debt into floating rate US dollar borrowings. For example, the group had fixed
rate debt of approximately US$4.9billion in 2007 as opposed to US$1.2billion in 2006.
The group anticipates that its earnings will reduce by US$158million if its US dollar
LIBOR interest rate increases by a half percentage point. (Rio Tinto Plc Annual Report,
2007).

How the Companies Use Derivatives.

Cadbury Scweppes uses both short-term and long-term cross currency and interest rate
swaps to manage hedge against currency risks and interest rate risks on its debt
obligations. Appendix 4 is a table showing the different derivatives used by the company
in 2007. For example, the company receives interest at floating rates of 3 months or 6
month LIBOR rates (or the local equivalent on Swaps where fixed interest rates are
payable. the company also maintains foreign exchange forward contracts. As at
December 2007. The fair value for its embedded derivatives amounted to £0.3million as
opposed to £0.6million in 2006. (Cadbury Schweppes Annual Report and Accounts,
2007). Appendix 5 shows the different derivatives and the sensitivity analysis on how a
10% weakening of the £ sterling as well as a 1% change in interest rates will affect
income. (Cadbury Schweppes Annual Report and Accounts, 2007).

Unlike Cadbury Scwheppes, Rio Tinto Plc does not endulge in too much use of
derivatives to hedge against exchange rate risk. The group rather has a diversified
portfolio of commodities and markets which have different responses to movements in
business cycles such as exchange rates, interest rates and inflation rates. Commodity
prices and currencies in various countries that the group operate are related in such a way
that the company achieves a long-term natural hedge. The group also borrows at floating
US $ interest rate which enables it to counteract the effect of economic and commodity
prices. This therefore limits its use for derivatives and other synthetic protective
instruments.

Implications to Investors

The implications to investors for the different risks identified above as well as the
policies used by the different companies to mitigate these risk is that investors must
understand that such risks are bound to exist so long as a company operates in different
countries and there are movements in business cycles. Consequently, investors must
select a company that adopts the best policy towards managing these risks. However,
despite how much effort is made towards reducing these risks, not all of the risks can be
hedged. Investors must therefore bear part of the risk when investing in these companies.
According to the Capital Asset Pricing Model and Arbitrage Pricing Theory, market risk
cannot be diversified completely. Interest rate risk and currency risks are examples of
market risks. (Ross et al., 1999; Bodie et al., 2005). Consequently, investors must bear
some of the risks and demand a risk premium for doing so.