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33. Financial instruments and risk management
The group holds or issues financial instruments mainly to finance its operations; for the temporary investment of short-
term funds; and to manage the currency and interest rate risks arising from its operations and from its sources of
finance. In addition, various financial instruments – for example trade debtors and trade creditors – arise directly from
the group’s operations.
The group finances its operations primarily by a mixture of issued share capital, retained profits, deferred taxation,
long-term loans and short-term loans, principally by issuing commercial paper and medium-term notes. The group
borrows in the major long-term debt markets in major currencies. Typically, but not exclusively, the bond markets
provide the most cost-effective means of long-term borrowing. The group uses derivative financial instruments
primarily to manage its exposure to market risks from changes in interest and foreign exchange rates. The derivatives
used for this purpose are principally interest rate swaps, gilt locks, currency swaps and forward currency contracts.
The types of financial instrument used for investment of short-term funds are prescribed in group treasury policies
with limits on the exposure to any one organisation. Short-term investing in financial instruments is undertaken on
behalf of the group by substantial external fund managers who are limited to dealing in debt instruments and certain
defined derivative instruments and are given strict guidelines on credit, diversification and maturity profiles.
During the year ended 31 March 2005, the group’s net debt reduced from £8.4 billion to £7.8 billion mainly from
working capital inflows and proceeds from the sale of investments. During the 2005 financial year, the group
restructured some of its swaps portfolio. As a result, the group terminated £2.9 billion of cross-currency and sterling
interest rate swaps with some swaps being replaced with new swaps which had the same economic hedging effect. This
resulted in the group paying £107 million in reducing gross debt and receiving a net £14 million of interest receipts.
The interest receipts and payments on restructuring have been included within deferred income and other debtors
respectively and will be amortised to the profit and loss account over the term of the underlying hedged debt. The
group’s fixed:floating interest rate profile on net debt is 95:5 at 31 March 2005.
During the year ended 31 March 2004, the group’s net debt reduced from £9.6 billion to £8.4 billion mainly from
working capital inflows. During the 2004 financial year, the group restructured some of its swaps portfolio to mitigate
credit risk to certain counter parties. As a result, the group terminated £7 billion of cross-currency interest rate swaps
and replaced these with new swaps which had the same economic hedging effect. This resulted in the group paying
£445 million in reducing gross debt and receiving £420 million of interest. The interest receipt has been included in
deferred income and will be amortised to the profit and loss account over the term of the underlying debt. The group’s
fixed:floating interest rate profile on net debt was 76:24 at 31 March 2004.
During the year ended 31 March 2003, the group’s net debt reduced from £13.7 billion to £9.6 billion. £2.6 billion
was realised from the disposal of the group’s interest in Cegetel Groupe SA in the year, and the group has closed out
£2.6 billion of associated fixed interest rate swaps. The group’s fixed:floating interest rate profile on net debt therefore
remained at 88:12 at 31 March 2003.
The group uses financial instruments to hedge some of its currency exposures arising from its non-UK assets,
liabilities and forward purchase commitments. The group also hedges some of its interest liabilities. The financial
instruments used comprise borrowings in foreign currencies, forward foreign currency exchange contracts, gilt locks and
interest and currency swaps.
There has been no change in the nature of the group’s risk profile between 31 March 2005 and the date of these
financial statements.
The notional amounts of derivatives summarised below do not necessarily represent amounts exchanged by the
parties and, thus, are not necessarily a measure of the exposure of the group through its use of derivatives. The
amounts exchanged are calculated on the notional amounts and other terms of the derivatives which relate to interest
and exchange rates.
(a) Interest rate risk management
The group has entered into interest rate swap agreements with banks and other institutions to vary the amounts and
periods for which interest rates on borrowings are fixed. Under interest rate swaps, the group agrees with other parties
to exchange, at specified intervals, the differences between fixed rate and floating rate interest amounts calculated by
reference to an agreed notional principal amount. Under gilt locks, forward sales of UK government long-dated treasury
stock were entered into for periods of up to one year. This hedge effectively fixed in the interest on part of the group’s
then future borrowings, all of which have now been taken on.
At 31 March 2005, the group had outstanding interest rate swap agreements having a total notional principal
amount of £5,297 million (2004 – £5,210 million).
(b) Foreign exchange risk management
Cross currency swaps and forward foreign exchange contracts have been entered into to reduce the foreign currency
exposure on the group’s operations and the group’s net assets. The group also enters into forward foreign exchange
contracts to hedge investments, interest expense and purchase and sale commitments denominated in foreign
currencies (principally US dollars and the euro). The remaining terms of the currency swaps are up to 26 years and the
terms of currency forward exchange contracts are typically less than one year.
The purpose of the group’s foreign currency hedging activities is to protect the group from the risk that the eventual
net inflows and net outflows will be adversely affected by changes in exchange rates.
At 31 March 2005, the group had outstanding foreign currency swap agreements and forward exchange contracts
having a total notional principal amount of £9,819 million (2004 – £11,367 million).
106 BT Group plc Annual Report and Form 20-F 2005 Notes to the financial statements