K. Derivatives and hedging transactions
The company operates in multiple functional currencies and is a significant borrower and lender in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity price changes and client credit risk. The company limits these risks by following established risk management policies and procedures, including the use of derivatives, and, where cost effective, financing with debt in the currencies in which assets are denominated. For interest rate exposures, derivatives are used to align rate movements between the interest rates associated with the company’s lease and other financial assets and the interest rates associated with its financing debt. Derivatives are also used to manage the related cost of debt. For foreign currency exposures, derivatives are used to limit the effects of foreign exchange rate fluctuations on financial results.
As a result of the use of derivative instruments, the company is exposed to the risk that counterparties to derivative contracts will fail to meet their contractual obligations. To mitigate the counterparty credit risk, the company has a policy of only entering into contracts with carefully selected major financial institutions based upon their credit ratings and other factors, and maintains strict dollar and term limits that correspond to each institution’s credit rating. The company’s established policies and procedures for mitigating credit risk on principal transactions include reviewing and establishing limits for credit exposure and continually assessing the creditworthiness of counterparties. Master agreements with counterparties include master netting arrangements as further mitigation of credit exposure to counterparties. These arrangements permit the company to net amounts due from the company to a counterparty with amounts due to the company from a counterparty reducing the maximum loss from credit risk in the event of counterparty default.
The company employs derivative instruments to hedge the volatility in stockholders’ equity resulting from changes in currency exchange rates of significant foreign subsidiaries of the company with respect to the U.S. dollar. These instruments, designated as net investment hedges in accordance with SFAS No. 133, expose the company to liquidity risk as the derivatives have an immediate cash flow impact upon maturity which is not offset by the translation of the underlying hedged equity. The company has established cash loss limits to monitor and manage this liquidity risk. In 2007, the company expended $258 million, all in the fourth quarter, related to maturities of net investment hedges. At December 31, 2007, the company had liabilities of $937 million, representing the fair value of derivative instruments in qualifying net investment hedge relationships. Of this amount, $495 million is expected to mature in fiscal 2008. The weighted-average remaining maturity of all derivative instruments designated as net investment hedges is approximately 1.5 years.
In its hedging programs, the company uses forward contracts, futures contracts, interest-rate swaps and currency swaps, depending upon the underlying exposure. The company does not use derivatives for trading or speculative purposes, nor is it a party to leveraged derivatives.
A brief description of the major hedging programs follows.
Debt risk management
The company issues debt in the global capital markets, principally to fund its financing lease and loan portfolio. Access to cost-effective financing can result in interest rate and/or currency mismatches with the underlying assets. To manage these mismatches and to reduce overall interest cost, the company uses interest-rate swaps to convert specific fixed-rate debt into variable-rate (or “floating-rate”) debt (i.e., fair value hedges) and to convert specific variable-rate debt into fixed-rate debt (i.e., cash flow hedges).
The company is exposed to exchange rate volatility on foreign currency denominated debt. To manage this risk, the company employs cross-currency swaps to convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. These swaps are accounted for as cash flow hedges.
The company is exposed to interest rate volatility on forecasted debt issuances. To manage this risk, the company may use forward starting interest-rate swaps to lock in the rate on the interest payments related to the forecasted debt issuance. These swaps are accounted for as cash flow hedges.
At December 31, 2007 and 2006, the weighted-average remaining maturity of all swaps in the debt risk management program was approximately five years.
Long-term investments in foreign subsidiaries (net investment)
A significant portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment which reduces the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses currency swaps and foreign exchange forward contracts for this risk management purpose, as well as a component of its debt management program. The currency effects of these hedges (approximately $880 million losses in 2007, $350 million losses in 2006 and $570 million gains in 2005, net of tax) were reflected in the Accumulated gains and (losses) not affecting retained earnings section of the Consolidated Statement of Stockholders’ Equity, thereby offsetting a portion of the translation adjustment of the applicable foreign subsidiaries’ net assets.
Anticipated royalties and cost transactions
The company’s operations generate significant nonfunctional currency, third-party vendor payments and intercompany payments for royalties and goods and services among the company’s non-U.S. subsidiaries and with the parent company. In anticipation of these foreign currency cash flows and in view of the volatility of the currency markets, the company selectively employs foreign exchange forward contracts to manage its currency risk. These forwards are accounted for as cash flow hedges. The maximum length of time over which the company is hedging its exposure to the variability in future cash flows is approximately four years. At December 31, 2007, the weighted-average remaining maturity of these derivative instruments was approximately 281 days, as compared to 216 days at December 31, 2006.
Anticipated commodity purchase transactions
In connection with the purchase of electricity for anticipated manufacturing requirements, the company selectively employs forward contracts to manage its price risk. The forwards are accounted for as cash flow hedges. The company does not have any derivative instruments relating to this program outstanding at December 31, 2007.
Subsidiary cash and foreign currency asset/liability management
The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than one year. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in Other (income) and expense in the Consolidated Statement of Earnings.
Equity risk management
The company is exposed to equity price changes related to certain obligations to employees. These equity exposures are primarily related to market price movements in certain broad equity market indices and in the company’s common stock. Changes in the overall value of these employee compensation obligations are recorded in SG&A expense in the Consolidated Statement of Earnings. Although not designated as accounting hedges, the company utilizes equity derivatives, including equity swaps and futures, to economically hedge the exposures related to certain employee compensation obligations. The derivatives are linked to the total return on certain broad equity market indices or the total return on the company’s common stock. They are recorded at fair value with gains or losses also reported in SG&A expense in the Consolidated Statement of Earnings.
Other derivatives
The company holds warrants in connection with certain investments that are deemed derivatives because they contain net share or net cash settlement provisions. The company records the changes in the fair value of these warrants in Other (income) and expense in the Consolidated Statement of Earnings.
The company is exposed to a potential loss if a client fails to pay amounts due under contractual terms (“credit risk”). The company utilizes credit default swaps to economically hedge its credit exposures. These derivatives have remaining terms of one year or less. The swaps are recorded at fair value with gains and losses reported in Other (income) and expense in the Consolidated Statement of Earnings.
To economically hedge its foreign exchange exposure not covered by any of the previously discussed programs, the company also uses certain forward and option contracts that are not designated as accounting hedges. These derivatives are recorded at fair value with gains and losses reported in Other (income) and expense in the Consolidated Statement of Earnings.
The following tables summarize the net fair value of the derivative instruments and the carrying value of foreign currency denominated debt designated as a hedge of net investment at December 31, 2007 and 2006 (included in the Consolidated Statement of Financial Position).
| ($ in millions) | ||||
| Hedge Designation | ||||
|---|---|---|---|---|
| At December 31, 2007 | Fair Value | Cash Flow | Net Investment | Non-Hedge/Other |
|
(a) Comprises assets of $181 million and liabilities of $14 million. (b) Comprises assets of $526 million and liabilities of $438 million. (c) Comprises liabilities of $937 million. (d) Comprises assets of $90 million and liabilities of $60 million. (e) Represents foreign currency denominated debt formally designated as a hedge of net investment. |
||||
| Derivatives—net asset/(liability): | ||||
| Debt risk management | $ 167 | $ 291 | $ — | $ 50 |
| Long-term investments in foreign subsidiaries (“net investments”) | — | — | (937) | — |
| Anticipated royalties and cost transactions | — | (203) | — | — |
| Anticipated commodity purchase transactions | — | — | — | — |
| Subsidiary cash and foreign currency asset/liability management | — | — | — | (56) |
| Equity risk management | — | — | — | 30 |
| Other derivatives | — | — | — | 6 |
| Total derivatives | 167(a) | 88(b) | (937)(c) | 30(d) |
| Debt: | ||||
| Long-term investments in foreign subsidiaries (“net investments”) | — | — | (2,787)(e) | — |
| Total | $ 167 | $ 88 | $ (3,724) | $ 30 |
| ($ in millions) | ||||
| Hedge Designation | ||||
|---|---|---|---|---|
| At December 31, 2006 | Fair Value | Cash Flow | Net Investment | Non-Hedge/Other |
|
(a) Comprises assets of $1 million and liabilities of $140 million. (b) Comprises assets of $293 million and liabilities of $269 million. (c) Comprises assets of $42 million and liabilities of $207 million. (d) Comprises assets of $74 million and liabilities of $134 million. (e) Represents foreign currency denominated debt formally designated as a hedge of net investment. |
||||
| Derivatives—net asset/(liability): | ||||
| Debt risk management | $ (139) | $ 110 | $ — | $ (96) |
| Long-term investments in foreign subsidiaries (“net investments”) | — | — | (165) | — |
| Anticipated royalties and cost transactions | — | (84) | — | — |
| Anticipated commodity purchase transactions | — | (2) | — | — |
| Subsidiary cash and foreign currency asset/liability management | — | — | — | (14) |
| Equity risk management | — | — | — | 40 |
| Other derivatives | — | — | — | 10 |
| Total derivatives | (139)(a) | 24(b) | (165)(c) | (60)(d) |
| Debt: | ||||
| Long-term investments in foreign subsidiaries (“net investments”) | — | — | (2,529)(e) | — |
| Total | $ (139) | $ 24 | $ (2,694) | $ (60) |
Accumulated derivative gains or losses
At December 31, 2007, in connection with its cash flow hedges of anticipated royalties and cost transactions, the company recorded net losses of $136 million, net of tax, in Accumulated gains and (losses) not affecting retained earnings. Of this amount, $174 million of losses are expected to be reclassified to Net income within the next year, providing an offsetting economic impact against the underlying anticipated transactions. At December 31, 2007, losses of approximately $91 million, net of tax, were recorded in Accumulated gains and (losses) not affecting retained earnings in connection with cash flow hedges of the company’s borrowings. Of this amount, $67 million of losses are expected to be reclassified to Net income within the next year, providing an offsetting economic impact against the underlying transactions.
The following table summarizes activity in the Accumulated gains and (losses) not affecting retained earnings section of the Consolidated Statement of Stockholders’ Equity related to all derivatives classified as cash flow hedges:
| ($ in millions, net of tax) | |
| Debit/(Credit) | |
|---|---|
| December 31, 2004 | $ 653 |
| Net losses reclassified into earnings from equity during 2005 | (104) |
| Changes in fair value of derivatives in 2005 | (787) |
| December 31, 2005 | (238) |
| Net gains reclassified into earnings from equity during 2006 | 205 |
| Changes in fair value of derivatives in 2006 | 138 |
| December 31, 2006 | 104 |
| Net losses reclassified into earnings from equity during 2007 | (116) |
| Changes in fair value of derivatives in 2007 | 239 |
| December 31, 2007 | $ 227 |
For the years ending December 31, 2007, 2006 and 2005, there were no significant gains or losses recognized in earnings representing hedge ineffectiveness or excluded from the assessment of hedge effectiveness (for fair value hedges and cash flow hedges), or associated with an underlying exposure that did not or was not expected to occur (for cash flow hedges); nor are there any anticipated in the normal course of business.
