Risk Report

A responsible approach to managing risks is a fundamental requirement for sustainable business success. Our activities are managed systematically according to the exact specifications of a comprehensive risk management system.

Our business environment is shaped by risks and opportunities. The following sections explain the risks to which the Volkswagen Group is exposed owing to its broad-based global services offering. Opportunities are outlined in the Report on Expected Developments.

GOALS AND FEATURES OF THE RISK MANAGEMENT SYSTEM
The goal of the Group’s risk management system is to identify potential risks at an early stage so that suitable measures can be taken to avert the threat of loss to the Company, and any risks that might jeopardize its continued existence can be ruled out.

By using an efficient risk management system, we are able to identify risks promptly, to assess them and to counter them. We are prepared to enter into transparent risks that are proportionate to the benefits expected from the business.

The risk management of the Volkswagen Group is an integral part of the structure and workflows within the business processes. It is coordinated centrally by Group Controlling in conjunction with Group Auditing, and its efficacy and adequacy are reviewed on a regular basis.

Responsibility for the risk monitoring system is decentralized, and lies with the individual divisions or the managing directors of equity investments. Through standardized written and verbal surveys by the Group companies’ risk managers, the Board of Management always has an overall picture of the current risk situation. If there are variations from planned levels, appropriate countermeasures can be introduced without delay.

Workflow rules, guidelines and instructions, together with descriptions of workflows, are systematically recorded and can for the most part be accessed online. Internal controls by the heads of the Group Auditing, Quality Assurance, Group Treasury, Brand Controlling and Group Controlling organizational units ensure that these rules are adhered to.

The effectiveness and adequacy of our risk management system has been assessed by the auditors, who established that all measures necessary for setting up an early warning system were taken appropriately and that the risks of future development were presented suitably. This means that we conform to the requirements of the Gesetz zur Kontrolle und Transparenz im Unternehmensbereich (KonTraG – German Act on Control and Transparency in Business). In addition, the Financial Services Division is also subject to regular special audits by the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin – the German Federal Financial Supervisory Authority) in accordance with section 44 of the Gesetz über das Kreditwesen (KWG – German Banking Act) and controls by association auditors.

INDIVIDUAL RISKS
The following information on individual risks relates to the 2007-to-2009 planning period.

MACROECONOMIC RISK
As regards global economic growth, we see particular risks in changes in energy and commodity prices, growing protectionism and ongoing imbalances in foreign trade. These factors could lead to greater changes in exchange rates, and in particular to a
continued weak US dollar, and a marked decline in global economic growth. In addition, changes in legislation, taxes or customs duties in individual countries could have a negative impact on business development.

The scenarios outlined above could also place considerable strains on the Volkswagen Group. We describe how we manage these risks in the following paragraphs on the individual risk categories.

SECTOR-SPECIFIC RISK
In 2006, the growth drivers of the global passenger car markets were once again Asia and South America. Eastern European markets also continued to record very positive growth. However, in some of these countries there are high customs barriers or minimum local content requirements for domestic production. These factors prevent a larger increase in sales volumes. Due to our substantial market coverage, we are exposed to risks in the traditional markets, particularly risks relating to price levels. Massive discounts, especially in the US passenger car market, but also in Western Europe and China, have further increased the pressure on the entire sector. These underlying conditions force us to intensify our sales promotion activities. As a supplier of volume models, we would be particularly affected if competing manufacturers were to step up their sales incentives again. We continue to approve loans for vehicle finance on the basis of the same cautious principles applied in the past, taking into account regulatory requirements of section 25a(1) of the KWG (German Banking Act).

Since we sell the majority of our vehicles in Western Europe, we would be especially hard hit by a fall in demand or prices in this market. We counter this risk with a clear, customer-oriented product and pricing policy. Our delivery volume outside Western Europe is widely diversified across the markets of North America, South America/South Africa, Asia Pacific and Central and Eastern Europe. We hold a leading position in a number of established and emerging markets. Accordingly, we are well able to balance shifts in volume between the individual markets. In addition, we are able to meet regional requirements by forming strategic partnerships.

The tougher conditions imposed on lenders by the Basel Capital Accord (Basel II) make it difficult for our dealerships and sales companies to finance their operations via bank loans. We have minimized the risk of dealership insolvency by developing our own system of dealer support, whereby we offer dealers financing on attractive terms via our financial services companies.

RESEARCH AND DEVELOPMENT RISK
There is always a risk that customers will not embrace our new products. We counter this risk by means of extensive trend analyses, customer surveys and scouting processes. Thus we can ensure that trends can be recognized at an early stage and that their relevance for our customers is verified in good time.

Another risk is that products or modules cannot be produced in accordance with the specified deadlines, costs or quality standards. We avoid this risk by continuously monitoring the progress of our projects and making changes to reflect the original targets. If there are deviations from targets, countermeasures can be taken in good time. Furthermore, our project organization ensures that all areas involved in the process work together effectively from an early stage. In this way, all those involved are given the opportunity to present their requirements and to plan their activities in good time.

Due to our wide variety of research and development activities, risks are not concentrated on particular patents or licenses.

PROCUREMENT RISK
The costs arising from persistently high commodity prices and the limited availability of certain commodities are countered by means of targeted strategies. Together with Research and Development, the Procurement area is investigating the use of alternative and recycled material. In addition, we are working intensively to extend our international supplier base. This includes above all supply sources for commodities on the Asian and Eastern European markets. There are also further risks relating to the tougher competition in the supplier industry. If any of our suppliers were to become insolvent, there is a risk of our production being interrupted. For this reason, we source our components from a number of different suppliers. In addition, we take the necessary precautions for supplier insolvency with our risk management system, in which we record information on the creditworthiness of European suppliers. This allows us to identify suppliers at risk of insolvency at an early stage and to take appropriate steps.

PRODUCTION RISKS RELATING TO DEMAND
Changes in global demand for passenger cars affect the number of vehicle types produced. Risks that arise from this, such as surplus capacity or supply shortages, are countered by our flexible production management. This is achieved firstly through our turntable concept, “multi-brand locations” and flexible working time models. Secondly, our modular strategy has created defined vehicle architectures that enable us to react flexibly to market events. We guard against potential economic risks arising from interruptions to production by taking out appropriate insurance.

RISKS ARISING FROM CHANGES IN DEMAND
To limit the impact on our business of fluctuations in demand or changing market conditions, we constantly analyze customer behavior and our competitors. In the largely saturated European markets, growth can only come about through predatory competition. The risks associated with this are hedged through our wide model range, which is constantly extended and modernized. In addition, we are expanding coverage along the value chain with the help of products from Volkswagen Financial Services AG.

Demand risks can also arise owing to further increases in oil prices. We counter these risks by developing fuel-efficient vehicles as part of our drivetrain and fuel strategy.

IMPORTANCE OF FLEET CUSTOMERS
For years, corporate customers have been gaining in importance as a segment of the overall market in Germany. With a share of over 44% in the fleet customer segment, the Volkswagen Group further extended its leading position in the market. Our position outside Germany is reinforced by means of Volkswagen Group Fleet International’s target group oriented customer care concept. In the major European markets, the Volkswagen Group increased deliveries by more than 10% year-on-year, thereby growing faster than the market. Default risks are not concentrated on individual corporate customers.

QUALITY RISK
Given the increasingly complex technology and the large number of suppliers, there are considerable challenges associated with quality assurance. In order to minimize quality-related risks from the outset, suppliers are involved in the development of new models. Suppliers in the automotive industry are also developing more and more expertise in the production of electronic components. In order for trends to be recognized quickly and action taken in this regard, it is important to transfer knowledge and to work with suppliers to develop standards and assurance measures for a level of quality that meets the expectations of our customers. Our close working relationship with all suppliers is a key requirement in this respect.

PERSONNEL RISK
The skills and knowledge of our employees constitute one of the most important success factors for the Volkswagen Group. There is a risk that know-how – and therefore advantages over our competitors – will be lost as a result of employee turnover and workforce reduction. The latest restructuring measures have increased this risk for the Group. Through intensive knowledge management, we are endeavoring to retain existing know-how in the company and to transfer it to other employees. As well as this, our wide range of training ensures that we have highly skilled new employees.

ENVIRONMENTAL PROTECTION REGULATIONS
On July 1, 2002, the European End-of-Life Vehicles Directive was transposed into German law by way of the Altfahrzeuggesetz (German End-of-Life Vehicles Act). This act guarantees that end-of-life vehicles will be disposed of free of charge through the collection points designated by manufacturers and importers. This initially applied only to vehicles registered after the law came into force, but from January 2007, it will be extended to all end-of-life vehicles. At present, we are unable to conclusively assess the impact of the EU’s eastward enlargement on the collection of end-of-life vehicles. As a result, no clear forecast can be made regarding the likely financial burden on the Volkswagen Group in certain EU member states. The adequacy of our existing provisions has been reviewed. In addition, our systems and cooperation arrangements for disposing of end-of-life vehicles offer us the opportunity to manage this risk.

Conventional air conditioning systems still contain hydrochlorofluorocarbons (HCFCs) as a cooling agent. EU legislation states that, as of January 1, 2010, HCFCs may only be used as a recycled material in existing systems for the purpose of maintenance. As of January 1, 2015, the use of all HCFCs will be prohibited in Europe. Without sufficiently early investment in alternatives, this could lead to production facilities being shut down temporarily, which in turn would lead to loss of production. In view of this, Volkswagen will prepare and implement a program in the coming years in order to phase out the use of this agent.

Chlorine-free fluorocarbon (FC) refrigerants, which were introduced in the past to replace the aforementioned HCFCs, are also subject to restrictions owing to their global warming potential. As of mid-2007, there will be increased requirements for maintaining systems and verifying the absence of leaks. This means that, depending on their size, systems must be inspected several times a year by certified refrigeration specialists.

Furthermore, there is a general risk of increased environmental protection regulations with a view to limiting global carbon dioxide emissions.

As regards EU emissions legislation, stricter requirements are expected to be introduced, primarily affecting diesel technology. However, in the case of light and medium passenger cars, these requirements are met by optimizing current technology. The exceptional status granted to heavy passenger cars, based on the threshold values of light commercial vehicles, is currently the subject of political debate. As the automotive industry has no experience of emissions aftertreatment for diesel vehicles and as the technology that must now be developed necessitates additional equipment and servicing, it is not possible to predict how customers will accept heavy passenger cars if this special status is withdrawn. The cost difference compared with petrol engines will also increase further. In future, diesel engines will also have to reposition themselves with regard to the obligation to add biofuels to fossil fuels, since diesel particulate filter technology does not permit any significant increase in the amount of biofuels added.

LEGAL CASES
An action was filed by Liverpool Limited Partnership, Bermuda, at the Braunschweig Regional Court challenging resolutions adopted by the Annual General Meeting on June 7, 2001, relating to approval of the actions of the members of the Board of Management and of the Supervisory Board for fiscal year 2000 and to the authorization to acquire treasury shares issued on that occasion. The authorization expired in 2002, so that the action regarding the authorization resolution was declared by both parties to be settled. As regards the approval of the actions of Board of Management members, Braunschweig Regional Court suspended proceedings on November 6, 2006; no ruling has yet been issued.

On June 29, 2001, the European Commission imposed a fine of €31.0 million on Volkswagen AG for alleged influencing of dealer pricing at the market launch of the Passat. Following the appeal lodged by Volkswagen AG on September 10, 2001, the European Court of First Instance declared the fine null and void on December 3, 2003. An appeal lodged against this ruling by the European Commission was rejected by the European Court of Justice on July 13, 2006, thereby confirming the legal opinion of Volkswagen AG.

The public prosecutor’s office in Braunschweig has carried out investigations following criminal charges filed by Volkswagen AG in June 2005 relating to the establishment of front companies, false expenses claims and privileges for works council members. At the beginning of July 2005, Volkswagen AG had also commissioned auditors KPMG to conduct internal investigations. As not all of the investigations have yet been completed, it has not been possible to conclusively examine the possibility of recourse against the persons in question. Based on the findings in the KPMG report, Volkswagen AG has already received insurance settlements in the amount of €4.5 million.

RISKS ARISING FROM FINANCIAL INSTRUMENTS
Group Treasury risk management specifies principles and responsibilities for the monitoring, management and control of risks arising from financial instruments. The Executive Committee for Liquidity and Foreign Currency approves risk limits, authorized financial instruments, hedging methods and horizons, and decides on the introduction of country risk limits.

Our operating activities entail financial risks arising from changes in interest rates, exchange rates and commodity prices. We reduce these risks by employing primary and derivative financial instruments. We only enter into derivative transactions with banks and commodity traders with good credit ratings. Interest rates and currencies are mainly managed centrally by Group Treasury.

The Group guards against interest rate risk and risks arising from fluctuations in the value of financial instruments by means of interest rate swaps, cross-currency swaps and other interest rate contracts. Financing extended to subsidiaries within the Volkswagen Group is usually hedged by matching the amount and maturity of the refinancing.

Through the flexible management of production capacity at our global locations we are able to use “natural hedging” to reduce currency risks. The remaining currency risk is hedged by means of cash flow and financial hedging instruments such as forward exchange transactions, currency options and cross-currency swaps. We use these transactions to limit the currency risk associated with forecasted foreign-currency cash flows from operating activities and intra-Group financing. We hedge cash flows expected from foreign-currency sales revenues and materials purchases on a net basis by means of forward exchange transactions and currency options. Depending on the market assessment, these contracts have a term of up to five years. These transactions are mainly used to hedge the euro against the US dollar, the pound sterling, the Swiss franc, the Japanese yen and the Swedish krone. Together, these five currencies make up around 90% of our exchange rate risk from cash flows.

Risks that can arise from the purchase of raw materials relate to availability and prices. We limit these risks by entering into commodity futures transactions. We have used appropriate contracts to hedge some of our requirements for aluminum, copper, lead, platinum, rhodium and palladium over a period of up to 60 months.

Information on financial assets, securities, derivative financial instruments, loans and trade accounts receivable and payable can be found in the Notes to our Consolidated Financial Statements, where we also explain our hedging policy, the hedging rules and credit and liquidity risks, and quantify the hedging transactions mentioned.

LIQUIDITY RISKS
In order to ensure that the Company is solvent at all times, we use a liquidity forecast with a fixed planning horizon.

We cover the capital requirements of the growing financial services business mainly through borrowings at matching maturities raised in the national and international financial markets. This will remain our preferred financing option in future, while loan finance will be used only for short-term working capital requirements and as a backup for debt issuance programs. We manage risks arising from cash flow fluctuations through liquidity reserves and confirmed credit lines. Given this extensive range of options, the Volkswagen Group faces no liquidity risk.

A rating downgrade could adversely affect the terms attached to the Volkswagen Group’s borrowings. Since fiscal year 2004, Volkswagen Bank GmbH has been given a separate rating by Moody’s Investors Service. This year, we were also able to obtain a separate rating for Volkswagen Bank GmbH from Standard & Poor’s. The rating given to Volkswagen Bank GmbH by both Standard & Poor’s and Moody’s Investors Service is one notch higher than that of Volkswagen AG and Volkswagen Financial Services AG. The ratings of both agencies are thus oriented more on Volkswagen Bank GmbH’s own business and financial situation. This represents a good opportunity for Volkswagen Bank GmbH to secure attractive borrowing terms. For information on our current ratings and new issues in the capital market in fiscal year 2006, please see the Financial Communication chapter.

The Treasury of Volkswagen Financial Services AG safeguards the liquidity of the Financial Services Division as well as managing interest rate risk. Controlling is responsible for measuring, analyzing and monitoring market risk positions.

RESIDUAL VALUE RISK IN THE FINANCIAL SERVICES BUSINESS
In the financial services business, we agree to buy back selected vehicles at a residual value fixed at inception of the contract so that we are able to realize market opportunities. We evaluate these lease contracts at regular intervals. We take the necessary precautions in the event of potential risks.

IT RISK
Our IT systems are protected against unauthorized access from outside by redundant firewall systems. Additional protection is provided by virus scanners and restricted physical and data access rights. The information security measures taken by the Group are constantly reviewed and updated. In addition, all data resources are backed up daily. Therefore, we consider the likelihood of a threat to the security of our data or information systems to be very low.

RISKS ARISING FROM RESTRUCTURING MEASURES
The restructuring measures undertaken in 2006 have improved the competitiveness of the Volkswagen Passenger Cars brand. These measures called for far-reaching adjustments, which could entail a range of risks if the existing underlying conditions were to change. This also applies to measures that are currently being pursued and those that are scheduled for the future. Nonetheless, we are confident that these decisions will prove effective and successful and that they will continue to drive the restructuring process.

OTHER FACTORS
In addition to the risks already outlined, there are other factors that cannot be predicted and are therefore difficult to manage. These could have an adverse effect on the further development of the Volkswagen Group. These factors include natural disasters, epidemics and terror attacks.

OVERALL RISK
Taking into account all the information known to us at present, no risks exist which could pose a threat to the continued existence of the Volkswagen Group.

REPORT ON POST-BALANCE SHEET DATE EVENTS
No other matters of particular significance occurred after the end of the fiscal year, beyond those already mentioned.