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Market risk

Significantly more attention is being paid to potentially major volatility of input prices in the construction sector that could complicate the budgeting process, completion of projects at planned costs, cause additional risks in carrying out fixed-price construction contracts and weaken projects’ profitability. Therefore, the overall economic development is being closely monitored and taking excessive price risks already in the bidding phase is avoided.

The residential development area is one of the main sources of market risk arising from the value of real estate for Merko Ehitus group. The real estate market has become more selective and in pre-launch risk assessment, consideration is given to such important aspects as the project’s location, development volume, planning solutions and the target group. Taking into account low interest rates on loans and limited supply on the market of new apartments, in the last three years the demand and transaction activity on the apartment market has grown moderately. Due to the selectiveness of the real estate market, setting the right sale price for new development projects in the given region have become very important. For hedging the area’s price risk, price statistics collected by the group and available from other public sources is being constantly analysed.

Market risk that is partially related to financial risks also includes currency risk and interest rate risk.

INTEREST RISK

Interest risk arises from interest rate changes in the financial markets as a result of which it may be necessary to revalue the group’s financial assets and take into consideration higher financing costs in the future. Most of the group’s bank loans have floating interest rates based on either Euribor or the interbank rates of the countries of incorporation of the entities. In 2016, the share of interest-bearing liabilities in the group’s capital structure decreased and management considers this share to be moderate (as at 31.12.2016, 19.3% and as at 31.12.2015, 14.8% of the balance sheet total) and effect of changes in the interest rate environment to be insignificant for the group’s results over the next 12 months.

Effect of changes in interest rate risk on finance costs: as at 31.12.2016, the group’s interest-bearing liabilities totalled EUR 46,001 thousand, of which short-term loans and repayments of long-term liabilities in 2017 totalled EUR 21,485 thousand and long-term loans and finance lease liabilities totalled EUR 24,516 thousand. As at 31.12.2016, the group’s loans granted totalled EUR 5,512 thousand, of which EUR 1,560 thousand were classified as short-term loans with repayments in 2017 and EUR 3,952 thousand as the long-term loans. Loan interest depended on interbank 1-12 month loan base interest in the entity’s domicile and Euribor.

The management does not expect big changes in base interest rates, the market is stable and base interest rates remain low. Assuming that average EURIBOR is 10 pp higher over the next 12 months as compared to the beginning of the year and there is no change in the position of liabilities, interest expenses would increase by EUR 33 thousand. All the loans granted have fixed interest rate and therefore a change in the reference rates would have no impact on the interest income.

In addition to risk arising from changes in Euribor, there is risk due to changes in the risk margin attributable to the changes in the economic environment related refinancing of liabilities. This is most directly manifested in a possible need to extend overdraft credit contracts. As at the year-end, group entities had entered in overdraft contracts with banks and other unrelated third parties in the total limit amount of EUR 11,198 thousand, of which EUR 3,000 thousand was withdrawn. In 2017, contracts in the total amount of EUR 11,198 thousand will expire, the extension of which is currently under consideration.

FOREIGN EXCHANGE RISK

The group’s economic activities are conducted mainly in the currencies of the countries of location of the companies: euros in Estonia, Latvia and Lithuania and kroons in Norway. Transactions within the group are conducted in euros as a rule. To eliminate foreign currency risks, close track is kept of the proportions of the company’s assets and liabilities held in different currencies and, when it comes to entering into long-term construction contacts, the euro is the preferred currency in the Baltics, and, in Norway, the krone. Considering the fact that the materials and services used in construction are generally from the local market or supplied from within the EU, the currency risk in the group is currently minimal.