Hedge Policy Of Avon

Published Date: 02 Nov 2017

Avon operates globally, through operations all around the world, and derives app. 83% of its consolidated income from its operations outside of the U.S. One risk connected with Avon’s international operations is that the functional currency for most of its global operations is the appropriate local currency. Because of this, changes in exchange rates may have a considerable impact on its cash flow, assets, earnings and financial position. Currencies for which the company has considerable exposures include for example the Australian dollar, Argentine peso, Brazilian real, Canadian dollar, British pound, Colombian peso, Chinese renminbi, the euro, Philippine peso, Mexican peso, Polish zloty, South Africa rand, Russian ruble, Turkish lira, Venezuelan bolívar and Ukrainian hryvnia. Time by time, the company uses foreign currency hedging and risk management strategies to decrease its exposure to fluctuations in cash flows and earnings linked to movements in foreign exchange rates. There can be no guarantee that foreign currency fluctuations will not have a material unfavourable effect on its business, results of operations and financial condition. (Avon, 2011)

Another risk related to Avon’s international operations is the likelihood that a foreign government may inflict currency remittance restrictions. Due to the likelihood of government restrictions on taking cash out of the country and control of exchange rates, the company may not be able to instantly send home cash at the official exchange rate or if the official exchange rate decreases, it may have a material unfavourable effect on its business, results of operations and financial condition. For example, currency restrictions announced by the Venezuelan government in 2003 have become stricter and have impacted the ability of its Venezuelan subsidiary (Avon Venezuela) to get foreign currency at the official rate to purchase imported products. Unless the situation becomes more favourable, Avon Venezuela’s operations will continue to be negatively affected as it will have to get more of its foreign currency requirements from non-government sources where the exchange rate is worse than the official rate. (Avon, 2011)

Inflation is another risk linked with the company’s worldwide operations. For example, Venezuela has been classified as a highly inflationary economy. Losses and gains deriving from the revaluation of the financial statements of subsidiaries in highly inflationary economies are showed in earnings. Given Venezuela’s description as a highly inflationary economy and the depression of the official rate, Avon’s operating profit, revenue and net income will be negatively affected in 2013 and beyond. Furthermore, there can be no guarantee that other economies in which it is present will not also become highly inflationary and that its earnings will not be unfavourably affected as a result. (Avon, 2011)

The overall goal of the company’s financial risk management is to decrease the potential unfavourable effects from movements in foreign exchange and interest rates deriving from its business performance. It may diminish its exposure to fluctuations in cash flows related to movements in interest rates and foreign exchange rates by making counterbalancing positions through the use of derivative financial instruments and through operational means. Since Avon uses foreign currency rate-sensitive and interest rate-sensitive instruments to hedge a part of its active and forecasted transactions, it hopes that any loss in value for the hedge instruments in general would be balanced by changes in the value of the underlying transactions. The company doesn’t enter into derivative financial instruments for trading or speculative reasons, nor is it dealing with leveraged derivatives. (Avon, 2011)

The company’s hedges of its foreign currency exposure are not used to, and, therefore, cannot totally reduce the effect of movements in foreign exchange rates on its consolidated financial situation, results of operations and cash flows. Avon’s foreign-currency financial instruments were valued at year-end to find out their sensitivity to foreign exchange rate movements. Based on its foreign exchange contracts at December 31, 2011, the effect of a theoretical 10% increase or 10% decrease in the U.S. dollar’s value against its foreign exchange contracts would not cause a material potential change in cash flows, earnings or fair value. This potential change does not concern the company’s fundamental foreign currency exposures. The theoretical effect was computed on the open positions using forward rates at December 31, 2011, adjusted for an assumed 10% increase or 10% decrease in the U.S. dollar’s value against these hedging contracts. (Avon, 2011)

As mentioned previously Avon uses foreign currency-rate sensitive and interest-rate sensitive instruments to hedge a definite part of its existing and forecasted transactions, it hopes that any loss or gain in value of the hedge instruments in general would be compensated by changes in the value of the fundamental forecasted transactions. Derivatives are recorded in the balance sheet at their fair values. The following table shows the fair value of derivative instruments outstanding at December 31, 2011:

Table 1: Fair value of derivative instruments outstanding at December 31, 2011

(in million $)derivatives.png

Source: AVON, 2011 p79

When the company enters transactions with derivative instrument, it classifies the instrument as a fair value hedge, a net investment hedge, a cash flow hedge, or a non-hedge. The accounting for gains or losses in fair value of a derivative instrument depends on whether it had classified it and it qualified as part of a hedging transaction and further, on the type of hedging transaction. Changes in the fair value of a derivative that is classified as a fair value hedge, along with the changes in the hedged liability or asset that is assignable to the hedged risk are noted in earnings. Changes in the fair value of a derivative that is classified as a cash flow hedge are noted in. Changes in the fair value of a derivative that is classified as a hedge of a net investment in a foreign operation are noted in foreign currency translation adjustments within AOCI to the extent effective as a hedge. Changes in the fair value of a derivative not classified as a hedging instrument are realized in earnings in other expense, net on the Consolidated Income Statement. Realized changes in a derivative are noted on the Consolidated Cash Flows Statement consistent with the fundamental hedged item. (Avon, 2011)

The company evaluates, both at the hedge’s starting and on an ongoing basis, whether the derivatives that are highly effective in counterbalancing changes in cash flows or fair values of hedged items. Highly effective is the derivative if the cumulative changes in the fair value of it are between 85-125% of the cumulative changes in the fair value of the hedged item. The ineffective amount of a derivative’s gain or loss is noted in earnings in other expense, net on the Consolidated Income Statement. When the company finds out that a derivative is not highly effective as a hedge, hedge accounting is stopped. When it is likely that a hedged forecasted transaction will not happen, Avon stops hedge accounting for the affected part of the forecasted transaction, and reesteems gains or losses that were accumulated in AOCI to earnings in other expense, net on the Consolidated Income Statement. (Avon, 2011)

Debts are subject to interest rate risk. Avon uses interest-rate swap agreements, which successfully convert to a floating interest rate the fixed rate on long-term debt, to handle its interest rate exposure. The agreements are classified as fair value hedges. The company held interest rate swap agreements that effectively converted approx. 74% in 2011 and 2010, of its long-term, fixed rate borrowings to a floating interest rate based on LIBOR. Its total exposure to floating interest rates was approx. 82% in 2011, and 81% in 2010. The company had interest-rate swap agreements classified as fair value hedges of fixed-rate debt, with notional amounts totalling $1,725 in 2011. Unrealized gains were $147.6 in 2011, and $94.4in 2010, and were integrated within long-term debt. The company recorded a net gain of $53.2 in interest expense for these interest-rate swap agreements classified as fair value hedges during 2011, and a net gain of $66.8 during 2010. The effect on interest expense of these interest-rate swap agreements was counterbalanced by an equal and balancing effect in interest expense on the company’s fixed-rate debt. Occasionally, Avon may re-classify the hedging relationship of a receive-fixed/pay-variable interest-rate swap agreement. In these cases, it enters into receive-variable/pay-fixed interest-rate swap agreements that are made to counterbalance the gain or loss on the re-classified contract. In 2011, the organization had interest-rate swap agreements that are not classified as hedges with notional amounts totalling $250. Unrealized losses on these agreements were immaterial in 2010 and 2011. During 2011, the company noted an immaterial net loss in other expense, net associated with these unclassified interest-rate swap agreements. There was no hedge ineffectiveness for the years 2009, 2010, 2011, connected to these interest rate swaps. (Avon, 2011)

During 2007, the company became part in treasury lock agreements (the "locks") with notional amounts totalling $500.0 and expiry date of July 31, 2008. The locks were classified as cash flow hedges of the expected interest payments on $250.0 of the 2013 Notes and $250.0 of the 2018 Notes. $38.0 losses on the locks were noted in AOCI. $19.2 losses are being amortized to interest expense over five years and $18.8 losses are being amortized over ten years. During 2005, Avon became part in treasury lock agreements that it classified as cash flow hedges and used to hedge exposure to a probable increase in interest rates before the expected issuance of ten- and 30-year bonds. In December 2005, the company decided that a more proper strategy was to issue 5-year bonds given its strong cash flow and high level of cash and cash equivalents. Consequently the company de-designated the locks as hedges and reclassified the gain of $2.5 on the locks from AOCI to other expense, net. A the same time Avon became part in a treasury lock agreement with a notional amount of $250.0 classified as a cash flow hedge of the $500.0 amount of five-year notes payable issued in January 2006. The loss on the 2005 lock agreement of $1.9 was showed in AOCI and is being amortized to interest expense over five years. During 2003, the company became part in treasury lock agreements that it classified as cash flow hedges and used to hedge the exposure to the probable increase in interest rates before the issue of the 4.625% Notes. The loss of $2.6 was noted in AOCI and is being amortized to interest expense over ten years. (Avon, 2011)