Note 5 Financial instruments

The Company is exposed to certain currency, commodity, interest rate and equity risks arising from its global operating, financing and investing activities. The Company uses derivative instruments to reduce and manage the economic impact of these exposures.

Currency risk

Due to the global nature of the Company’s operations, many of its subsidiaries are exposed to currency risk in their operating activities from entering into transactions in currencies other than their functional currency. To manage such currency risks, the Company’s policies require the subsidiaries to hedge their foreign currency exposures from binding sales and purchase contracts denominated in foreign currencies. For forecasted foreign currency denominated sales of standard products and the related foreign currency denominated purchases, the Company’s policy is to hedge up to a maximum of 100 percent of the forecasted foreign currency denominated exposure, depending on the length of the forecasted exposures. Forecasted exposures greater than 12 months are not hedged. Forward foreign exchange contracts are the main instrument used to protect the Company against the volatility of future cash flows (caused by changes in exchange rates) of contracted and forecasted sales and purchases denominated in foreign currencies. In addition, within its treasury operations, the Company primarily uses foreign exchange swaps and forward foreign exchange contracts to manage the currency and timing mismatches arising in its liquidity management activities.

Commodity risk

Various commodity products are used in the Company’s manufacturing activities. Consequently, it is exposed to volatility in future cash flows arising from changes in commodity prices. To manage the price risk of commodities other than electricity, the Company’s policies require that the subsidiaries hedge the commodity price risk exposures from binding contracts, as well as at least 50 percent (up to a maximum of 100 percent) of the forecasted commodity exposure over the next 12 months or longer (up to a maximum of 18 months). In certain locations where the price of electricity is hedged, up to a maximum of 90 percent of the forecasted electricity needs, depending on the length of the forecasted exposures, are hedged. Swap and futures contracts are used to manage the associated price risks of commodities.

Interest rate risk

The Company has issued bonds at fixed rates. Interest rate swaps are used to manage the interest rate risk associated with such debt. In addition, from time to time, the Company uses instruments such as interest rate swaps, bond futures or forward rate agreements to manage interest rate risk arising from the Company’s balance sheet structure but does not designate such instruments as hedges.

Equity risk

The Company is exposed to fluctuations in the fair value of its warrant appreciation rights (WARs) issued under its MIP. A WAR gives its holder the right to receive cash equal to the market price of an equivalent listed warrant on the date of exercise. To eliminate such risk, the Company has purchased cash-settled call options which entitle the Company to receive amounts equivalent to its obligations under the outstanding WARs.

In general, while the Company’s primary objective in its use of derivatives is to minimize exposures arising from its business, certain derivatives are designated and qualify for hedge accounting treatment while others either are not designated or do not qualify for hedge accounting.

Volume of derivative activity

Foreign exchange and interest rate derivatives

The gross notional amounts of outstanding foreign exchange and interest rate derivatives (whether designated as hedges or not) were as follows:

(XLS:)

Type of derivative

Total notional amount

December 31, ($ in millions)

2011

2010

2009

Foreign exchange contracts

16,503

16,971

14,446

Embedded foreign exchange derivatives

3,439

2,891

3,951

Interest rate contracts

5,535

2,357

2,860

Derivative commodity contracts

The following table shows the notional amounts of outstanding commodity derivatives (whether designated as hedges or not), on a net basis, to reflect the Company’s requirements in the various commodities:

(XLS:)

Type of derivative

Unit

Total notional amount

December 31,

 

2011

2010

2009

Copper swaps

metric tonnes

38,414

20,977

22,002

Aluminum swaps

metric tonnes

5,068

3,050

2,193

Nickel swaps

metric tonnes

18

36

24

Lead swaps

metric tonnes

13,325

9,525

Zinc swaps

metric tonnes

125

Silver swaps

ounces

1,981,646

Electricity futures

megawatt hours

326,960

363,340

367,748

Crude oil swaps

barrels

113,397

121,979

154,632

Equity derivatives

At December 31, 2011, 2010 and 2009, the Company held 61 million, 58 million and 64 million cash-settled call options on ABB Ltd shares with a total fair value of $21 million, $45 million and $64 million, respectively.

Cash flow hedges

As noted above, the Company mainly uses forward foreign exchange contracts to manage the foreign exchange risk of its operations, commodity swaps to manage its commodity risks and cash-settled call options to hedge its WAR liabilities. Where such instruments are designated and qualify as cash flow hedges, the effective portion of the changes in their fair value is recorded in “Accumulated other comprehensive loss” and subsequently reclassified into earnings in the same line item and in the same period as the underlying hedged transaction affects earnings. Any ineffectiveness in the hedge relationship, or hedge component excluded from the assessment of effectiveness, is recognized in earnings during the current period.

At December 31, 2011, 2010 and 2009, “Accumulated other comprehensive loss” included net unrealized gains of $12 million, $92 million and $20 million, respectively, net of tax, on derivatives designated as cash flow hedges. Of the amount at December 31, 2011, net gains of $8 million are expected to be reclassified to earnings in 2012. At December 31, 2011, the longest maturity of a derivative classified as a cash flow hedge was 74 months.

In 2011, 2010 and 2009, the amounts of gains or losses, net of tax, reclassified into earnings due to the discontinuance of cash flow hedge accounting and recognized in earnings due to ineffectiveness in cash flow hedge relationships were not significant.

The pre-tax effects of derivative instruments, designated and qualifying as cash flow hedges, on “Accumulated other comprehensive loss” and the Consolidated Income Statements were as follows:

(XLS:)

Type of derivative
designated as
a cash flow hedge

2011

Gains
(losses)
recognized
in OCI(1)
on derivatives
(effective portion)

Gains (losses)
reclassified from
OCI(1) into income
(effective portion)

Gains (losses)
recognized in
income (ineffective
portion and amount
excluded from
effectiveness testing)

($ in millions)

Location

($ in millions)

Location

($ in millions)

(1)

OCI represents “Accumulated other comprehensive loss”.

(2)

SG&A expenses represent “Selling, general and administrative expenses”.

Foreign exchange contracts

11

Total revenues

113

Total revenues

 

 

Total cost of sales

(9)

Total cost of sales

Commodity contracts

(17)

Total cost of sales

2

Total cost of sales

Cash-settled call options

(21)

SG&A
expenses(2)

(18)

SG&A
expenses(2)

Total

(27)

 

88

 

(XLS:)

Type of derivative
designated as
a cash flow hedge

2010

Gains
(losses)
recognized
in OCI(1)
on derivatives
(effective portion)

Gains (losses)
reclassified from
OCI(1) into income
(effective portion)

Gains (losses)
recognized in
income (ineffective
portion and amount
excluded from
effectiveness testing)

($ in millions)

Location

($ in millions)

Location

($ in millions)

(1)

OCI represents “Accumulated other comprehensive loss”.

(2)

SG&A expenses represent “Selling, general and administrative expenses”.

Foreign exchange contracts

107

Total revenues

36

Total revenues

2

 

 

Total cost of sales

(4)

Total cost of sales

Commodity contracts

9

Total cost of sales

8

Total cost of sales

1

Cash-settled call options

(4)

SG&A
expenses(2)

(11)

SG&A
expenses(2)

Total

112

 

29

 

3

(XLS:)

Type of derivative
designated as
a cash flow hedge

2009

Gains
(losses)
recognized
in OCI(1)
on derivatives
(effective portion)

Gains (losses)
reclassified from
OCI(1) into income
(effective portion)

Gains (losses)
recognized in
income (ineffective
portion and amount
excluded from
effectiveness testing)

($ in millions)

Location

($ in millions)

Location

($ in millions)

(1)

OCI represents “Accumulated other comprehensive loss”.

(2)

SG&A expenses represent “Selling, general and administrative expenses”.

Foreign exchange contracts

84

Total revenues

(91)

Total revenues

4

 

 

Total cost of sales

4

Total cost of sales

Commodity contracts

31

Total cost of sales

(40)

Total cost of sales

2

Cash-settled call options

8

SG&A
expenses(2)

(16)

SG&A
expenses(2)

Total

123

 

(143)

 

6

Derivative gains of $61 million and $19 million, both net of tax, were reclassified from “Accumulated other comprehensive loss” to earnings during 2011 and 2010, respectively. During 2009, derivative losses of $105 million, net of tax, were reclassified to earnings.

Fair value hedges

To reduce its interest rate exposure arising primarily from its debt issuance activities, the Company uses interest rate swaps. Where such instruments are designated as fair value hedges, the changes in fair value of these instruments, as well as the changes in fair value of the risk component of the underlying debt being hedged, are recorded as offsetting gains and losses in “Interest and other finance expense”. Hedge ineffectiveness of instruments designated as fair value hedges in 2011, 2010 and 2009, was not significant.

The effect of derivative instruments, designated and qualifying as fair value hedges, on the Consolidated Income Statements was as follows:

(XLS:)

 

2011

Type of derivative designated
as a fair value hedge

Gains (losses) recognized
in income on derivatives
designated as fair value hedges

Gains (losses) recognized
in income on hedged item

Location

($ in millions)

Location

($ in millions)

Interest rate contracts

Interest and other finance expense

(24)

Interest and other finance expense

24

Cross-currency swaps

Interest and other finance expense

Interest and other finance expense

Total

 

(24)

 

24

(XLS:)

 

2010

Type of derivative designated
as a fair value hedge

Gains (losses) recognized
in income on derivatives
designated as fair value hedges

Gains (losses) recognized
in income on hedged item

Location

($ in millions)

Location

($ in millions)

Interest rate contracts

Interest and other finance expense

(12)

Interest and other finance expense

12

Cross-currency swaps

Interest and other finance expense

Interest and other finance expense

Total

 

(12)

 

12

(XLS:)

 

2009

Type of derivative designated
as a fair value hedge

Gains (losses) recognized
in income on derivatives
designated as fair value hedges

Gains (losses) recognized
in income on hedged item

Location

($ in millions)

Location

($ in millions)

Interest rate contracts

Interest and other finance expense

41

Interest and other finance expense

(41)

Cross-currency swaps

Interest and other finance expense

3

Interest and other finance expense

(3)

Total

 

44

 

(44)

Derivatives not designated in hedge relationships

Derivative instruments that are not designated as hedges or do not qualify as either cash flow or fair value hedges are economic hedges used for risk management purposes. Gains and losses from changes in the fair values of such derivatives are recognized in the same line in the income statement as the economically hedged transaction.

Furthermore, under certain circumstances, the Company is required to split and account separately for foreign currency derivatives that are embedded within certain binding sales or purchase contracts denominated in a currency other than the functional currency of the subsidiary and the counterparty.

The gains (losses) recognized in the Consolidated Income Statements on derivatives not designated in hedging relationships are included in the table below:

(XLS:)

Type of derivative
not designated as a hedge

Gains (losses) recognized in income

($ in millions)

Location

2011

2010

2009

Foreign exchange contracts

Total revenues

(93)

436

389

 

Total cost of sales

(25)

(263)

(264)

 

Interest and other finance expense

265

563

70

Embedded foreign exchange contracts

Total revenues

(31)

(279)

(234)

 

Total cost of sales

11

17

51

Commodity contracts

Total cost of sales

(59)

38

96

 

Interest and other finance expense

1

Cross-currency swaps

Interest and other finance expense

2

Interest rate contracts

Interest and other finance expense

2

Cash-settled call options

Interest and other finance expense

(1)

(1)

1

Total

 

68

511

113

The fair values of derivatives included in the Consolidated Balance Sheets were as follows:

(XLS:)

 

Derivative assets

Derivative liabilities

December 31, 2011 ($ in millions)

Current in
“Other
current
assets”

Non-current
in “Other
non-current
assets”

Current in
“Provisions
and other
current
liabilities”

Non-current
in “Other
non-current
liabilities”

Derivatives designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

37

6

26

10

Commodity contracts

1

6

Interest rate contracts

40

Cash-settled call options

13

6

Total

51

52

32

10

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

142

38

289

28

Commodity contracts

9

1

33

3

Interest rate contracts

1

Cash-settled call options

1

1

Embedded foreign exchange derivatives

51

13

77

19

Total

203

53

399

51

Total fair value

254

105

431

61

(XLS:)

 

Derivative assets

Derivative liabilities

December 31, 2010 ($ in millions)

Current in
“Other
current
assets”

Non-current
in “Other
non-current
assets”

Current in
“Provisions
and other
current
liabilities”

Non-current
in “Other
non-current
liabilities”

Derivatives designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

106

39

23

12

Commodity contracts

8

Interest rate contracts

14

50

Cash-settled call options

18

25

Total

146

114

23

12

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

435

62

140

14

Commodity contracts

42

2

7

Interest rate contracts

1

Cash-settled call options

2

Embedded foreign exchange derivatives

23

4

134

50

Total

500

70

281

65

Total fair value

646

184

304

77

Although the Company is party to close-out netting agreements with most derivative counterparties, the fair values in the tables above and in the Consolidated Balance Sheets at December 31, 2011 and 2010, have been presented on a gross basis.

Financial review

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