NOTE 5 DERIVATIVES
We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities.
FOREIGN CURRENCY
Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Options and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of June 30, 2009, the total notional amount of such foreign exchange contracts was $7.2 billion. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of June 30, 2009, the total notional amount of these foreign exchange contracts sold was $3.5 billion. Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of June 30, 2009, the total notional amounts of these foreign exchange contracts purchased and sold were $3.2 billion and $3.6 billion, respectively.
EQUITY
Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2009, the total notional amounts of designated and non-designated equity contracts purchased and sold were immaterial.
INTEREST RATE
Securities held in our fixed-income portfolio are subject to different interest rate risks based on their various maturities. The average maturity of the fixed-income portfolio is managed to achieve economic returns which correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2009, the total notional amount of fixed-interest rate contracts purchased and sold were $2.7 billion and $456 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. These meet the definition of a derivative instrument under SFAS No. 133 in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2009, the total notional derivative amount of mortgage contracts purchased was $1.3 billion.
CREDIT
Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and facilitate portfolio diversification. We use credit default swaps as they are a low cost way of managing exposure to individual credit risks or groups of credit risks while continuing to improve liquidity. As of June 30, 2009, the total notional amounts of credit contracts purchased and sold were immaterial.
COMMODITY
We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. We use swap and futures contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they are low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2009, the total notional amounts of commodity contracts purchased and sold were $543 million and $33 million, respectively.
CREDIT-RISK-RELATED CONTINGENT FEATURES
Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, collateral will be required for posting, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2009, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral is required to be posted.
GROSS FAIR VALUES OF DERIVATIVE INSTRUMENTS (EXCLUDING FIN NO. 39(A) NETTING)
| June 30, 2009 | ||||||
| (In millions) | Foreign Exchange Contracts | Equity Contracts | Interest Rate Contracts | Credit Contracts | Commodity Contracts | Total Derivatives |
|---|---|---|---|---|---|---|
| Assets | ||||||
| Derivatives not designated as hedging instruments | ||||||
| Short-term investments | $())),9 | $ 78 | $))44 | $$ (21 | $,()2 | $))154 |
| Other current assets | 48 | – | – | – | – | 48 |
| Total | $,() 57 | $ 78 | $))44 | $$ )21 | $,()2 | $))202 |
| Derivatives designated as hedging instruments | ||||||
| Short-term investments | $ ,()12 | $$ – | $ $, – | $ $ ),– | $ ()– | $ (()12 |
| Other current assets | 417 | – | – | – | – | 417 |
| Equity and other investments | – | 2 | – | – | – | 2 |
| Total | $,(429 | $$ 2 | $$$ – | $ ()) – | $() – | $()431 |
| Total assets(b) | $,(486 | $ 80 | $()44 | $,()21 | $() 2 | $()633 |
| Liabilities | ||||||
| Derivatives not designated as hedging instruments | ||||||
| Other current liabilities | $(183) | $(3) | $(20) | $ (62) | $ (6) | $(274) |
| Derivatives designated as hedging instruments | ||||||
| Other current assets | $, (75) | $$ – | $,$)– | $ (() – | $(( – | $ ((75) |
| Total liabilities(b) | $(258) | $(3) | $(20) | $ (62) | $,(6) | $(349) |
| (a) | FIN No. 39, Offsetting of Amounts Related to Certain Contracts – an interpretation of APB No. 10 and FASB Statement No. 105, permits the netting of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. |
| (b) | See Note 6 – Fair Value Measurements. |
FAIR-VALUE HEDGES
For a derivative instrument designated as a fair-value hedge, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings.
During fiscal year 2009, we recognized in other income (expense) the following gains (losses) on fair value hedged derivatives and their related hedged items:
| (In millions) | Foreign Exchange Contracts | Equity Contracts | ||||
|---|---|---|---|---|---|---|
| Derivatives | $, 121 | $, 191 | ||||
| Hedged items | (120) | (211) | ||||
| Total | $,(() 1 | $ (20) |
CASH-FLOW HEDGES
For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain (loss) is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. During fiscal year 2009, we recognized the following gains (losses) related to foreign exchange contracts:
| (In millions) | ||
|---|---|---|
| Effective portion: | ||
| Gain recognized in OCI, net of tax effect of $472 | $()876 | |
| Gain reclassified from accumulated OCI into revenue | $()884 | |
| Amount excluded from effectiveness assessment and ineffective portion: | ||
| Loss recognized in other income (expense) | $(314) | |
We estimate that $528 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2009.
NON-DESIGNATED DERIVATIVES
Gains (losses) from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying securities and are recorded as a component of OCI. The amounts recognized during fiscal year 2009 were as follows:
| (In millions) | ||
|---|---|---|
| Foreign exchange contracts | $(234) | |
| Equity contracts | (131) | |
| Interest-rate contracts | 5 | |
| Credit contracts | (18) | |
| Commodity contracts | (126) | |
| Total | $(504) | |
Gains (losses) for foreign exchange, equity, interest rate, credit, and commodity contracts presented in other income statement line items were immaterial for fiscal year 2009 and have been excluded from the table above.