Note 5 Derivative 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 exposures, 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). Primarily swap contracts are used to manage the associated price risks of commodities. As of 2014, the Company no longer enters into electricity futures contracts to manage the price risk on its forecasted electricity needs in certain locations.

Interest rate risk

The Company has issued bonds at fixed rates. Interest rate swaps are used to manage the interest rate risk associated with certain debt and generally such swaps are designated as fair value hedges. In addition, from time to time, the Company uses instruments such as interest rate swaps, interest rate futures, 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.

Volume of derivative activity

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.

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:

Type of derivative

Total notional amounts

December 31, ($ in millions)

2014

2013

2012

Foreign exchange contracts

18,564

19,351

19,724

Embedded foreign exchange derivatives

3,013

3,049

3,572

Interest rate contracts

2,242

4,693

3,983

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:

Type of derivative

Unit

Total notional amounts

December 31,

 

2014

2013

2012

Copper swaps

metric tonnes

46,520

42,866

45,222

Aluminum swaps

metric tonnes

3,846

3,525

5,495

Nickel swaps

metric tonnes

18

21

Lead swaps

metric tonnes

6,550

7,100

13,025

Zinc swaps

metric tonnes

200

300

225

Silver swaps

ounces

1,996,845

1,936,581

1,415,322

Electricity futures

megawatt hours

279,995

334,445

Crude oil swaps

barrels

128,000

113,000

135,471

Equity derivatives

At December 31, 2014, 2013 and 2012, the Company held 61 million, 67 million and 67 million cash-settled call options indexed to ABB Ltd shares (conversion ratio 5:1) with a total fair value of $33 million, $56 million and $26 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, 2014, 2013 and 2012, “Accumulated other comprehensive loss” included net unrealized losses of $21 million and net unrealized gains of $22 million and $37 million, respectively, net of tax, on derivatives designated as cash flow hedges. Of the amount at December 31, 2014, net losses of $12 million are expected to be reclassified to earnings in 2015. At December 31, 2014, the longest maturity of a derivative classified as a cash flow hedge was 57 months.

In 2014, 2013 and 2012, 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” (OCI) and the Consolidated Income Statements were as follows:

Type of derivative
designated as
a cash flow hedge

2014

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

Gains (losses) reclassified from OCI 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)

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

Foreign exchange contracts

(42)

Total revenues

(9)

Total revenues

 

 

Total cost of sales

8

Total cost of sales

Commodity contracts

(7)

Total cost of sales

(3)

Total cost of sales

Cash-settled call options

(16)

SG&A expenses(1)

(6)

SG&A expenses(1)

Total

(65)

 

(10)

 

 

 

 

 

 

 

 

 

 

 

 

 

Type of derivative
designated as
a cash flow hedge

2013

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

Gains (losses) reclassified from OCI 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)

Foreign exchange contracts

22

Total revenues

52

Total revenues

 

 

Total cost of sales

(1)

Total cost of sales

Commodity contracts

(5)

Total cost of sales

(5)

Total cost of sales

Cash-settled call options

16

SG&A expenses(1)

8

SG&A expenses(1)

Total

33

 

54

 

 

 

 

 

 

 

 

 

 

 

 

 

Type of derivative
designated as
a cash flow hedge

2012

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

Gains (losses) reclassified from OCI 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)

Foreign exchange contracts

74

Total revenues

69

Total revenues

 

 

Total cost of sales

(12)

Total cost of sales

Commodity contracts

4

Total cost of sales

(4)

Total cost of sales

Cash-settled call options

(4)

SG&A expenses(1)

(11)

SG&A expenses(1)

Total

74

 

42

 

Net derivative losses of $9 million and net derivative gains of $43 million and $28 million, net of tax, were reclassified from “Accumulated other comprehensive loss” to earnings during 2014, 2013 and 2012, respectively.

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 the 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 2014, 2013 and 2012, was not significant.

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

 

2014

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

84

Interest and other finance expense

(83)

 

 

 

 

 

 

 

 

 

 

 

2013

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

(34)

Interest and other finance expense

35

 

 

 

 

 

 

 

 

 

 

 

2012

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

6

Interest and other finance expense

(6)

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 were as follows:

Type of derivative not designated as a hedge

Gains (losses) recognized in income

($ in millions)

Location

2014

2013

2012

(1)

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

Foreign exchange contracts

Total revenues

(533)

(95)

318

 

Total cost of sales

19

80

(193)

 

SG&A expenses(1)

2

(1)

(3)

 

Interest and other finance expense

(260)

223

68

Embedded foreign exchange contracts

Total revenues

149

101

(148)

 

Total cost of sales

(27)

(10)

28

Commodity contracts

Total cost of sales

(28)

(50)

10

 

Interest and other finance expense

1

1

1

Interest rate contracts

Interest and other finance expense

(1)

(3)

(1)

Cash-settled call options

Interest and other finance expense

(1)

Total

 

(679)

246

80

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

 

Derivative assets

Derivative liabilities

December 31, 2014 ($ in millions)

Current in
“Other current
assets”

Non-current in “Other non-current assets”

Current in
“Other current
liabilities”

Non-current in “Other non-current
liabilities”

Derivatives designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

9

9

20

16

Commodity contracts

3

Interest rate contracts

85

Cash-settled call options

21

11

Total

30

105

23

16

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

156

25

369

72

Commodity contracts

4

19

3

Cash-settled call options

1

1

Embedded foreign exchange derivatives

98

58

27

17

Total

259

84

415

92

Total fair value

289

189

438

108

 

 

 

 

 

Thereof, subject to close-out netting agreements

164

119

399

90

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

Derivative liabilities

December 31, 2013 ($ in millions)

Current in
“Other current
assets”

Non-current in “Other non-current assets”

Current in
“Other current
liabilities”

Non-current in “Other non-current liabilities”

Derivatives designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

21

8

10

3

Commodity contracts

2

1

Interest rate contracts

14

7

Cash-settled call options

14

40

Total

37

62

11

10

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

Foreign exchange contracts

272

42

121

30

Commodity contracts

6

1

15

1

Cash-settled call options

2

Embedded foreign exchange derivatives

57

21

55

11

Total

335

66

191

42

Total fair value

372

128

202

52

 

 

 

 

 

Thereof, subject to close-out netting agreements

284

63

130

40

Close-out netting agreements provide for the termination, valuation and net settlement of some or all outstanding transactions between two counterparties on the occurrence of one or more pre-defined trigger events.

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, 2014 and 2013, have been presented on a gross basis.