Note 6
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 its 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, the Company’s policies require that its 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.

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, indexed to the shares of the Company, 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:

 

Total notional amounts at December 31,

Type of derivative ($ in millions)

2018

2017

2016

Foreign exchange contracts

13,612

16,261

14,144

Embedded foreign exchange derivatives

733

899

1,125

Interest rate contracts

3,300

5,706

3,021

Derivative commodity contracts

The Company uses derivatives to hedge its direct or indirect exposure to the movement in the prices of commodities which are primarily copper, silver and aluminum. 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:

 

 

Total notional amounts at December 31,

Type of derivative

Unit

2018

2017

2016

Copper swaps

metric tonnes

46,143

28,976

17,667

Silver swaps

ounces

2,861,294

1,966,729

1,586,395

Aluminum swaps

metric tonnes

9,491

1,869

27

Equity derivatives

At December 31, 2018, 2017 and 2016, the Company held 41 million, 37 million and 47 million cash-settled call options indexed to ABB Ltd shares (conversion ratio 5:1) with a total fair value of $6 million, $42 million and $23 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, 2018, 2017 and 2016, “Accumulated other comprehensive loss” included net unrealized losses of $16 million, net unrealized gains of $12 million and net unrealized losses of $1 million, respectively, net of tax, on derivatives designated as cash flow hedges. Of the amount at December 31, 2018, net losses of $6 million are expected to be reclassified to earnings in 2019. At December 31, 2018, the longest maturity of a derivative classified as a cash flow hedge was 61 months.

In 2018, 2017 and 2016, the amounts of gains or losses, net of tax, reclassified into earnings due to the discontinuance of cash flow hedge accounting and the amount of ineffectiveness in cash flow hedge relationships directly recognized in earnings 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:

 

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

 

 

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

($ in millions)

2018

2017

2016

 

 

2018

2017

2016

(1)

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

Type of derivative

 

 

 

 

Location

 

 

 

Foreign exchange contracts

(6)

3

(7)

 

Total revenues

2

1

 

Total cost of sales

2

9

Commodity contracts

(9)

9

3

 

Total cost of sales

6

(2)

Cash-settled call options

(36)

22

15

 

SG&A expenses(1)

(22)

15

9

Total

(51)

34

11

 

 

(22)

25

17

The amounts in respect of gains (losses) recognized in income for hedge ineffectiveness and amounts excluded from effectiveness testing were not significant in 2018, 2017 and 2016.

Net derivative losses of $24 million and net derivative gains of $23 million and $14 million, net of tax, were reclassified from “Accumulated other comprehensive loss” to earnings during 2018, 2017 and 2016, 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 2018, 2017 and 2016, was not significant.

The effect of Interest rate contracts, designated and qualifying as fair value hedges, on the Consolidated Income Statements was as follows:

($ in millions)

2018

2017

2016

Gains (losses) recognized in Interest and other finance expense:

 

 

 

– on derivatives designated as fair value hedges

(4)

(23)

(28)

– on hedged item

5

27

30

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:

($ in millions)
Type of derivative not designated as a hedge

Gains (losses) recognized in income

Location

2018

2017

2016

(1)

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

Foreign exchange contracts

Total revenues

(121)

92

(90)

Total cost of sales

46

(41)

(28)

SG&A expenses(1)

10

(18)

8

Non-order related research and development

(1)

(1)

Interest and other finance expense

40

22

(35)

Embedded foreign exchange contracts

Total revenues

58

7

(5)

Total cost of sales

(4)

(2)

(4)

SG&A expenses(1)

2

5

(2)

Commodity contracts

Total cost of sales

(33)

31

31

Other

Interest and other finance expense

3

(2)

(7)

Total

 

94

(133)

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

 

December 31, 2018

 

Derivative assets

Derivative liabilities

($ 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

1

4

Commodity contracts

2

Interest rate contracts

35

1

Cash-settled call options

3

3

Total

3

38

3

5

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

Foreign exchange contracts

117

14

160

30

Commodity contracts

8

1

21

1

Embedded foreign exchange derivatives

15

10

8

1

Total

140

25

189

32

Total fair value

143

63

192

37

 

December 31, 2017

 

Derivative assets

Derivative liabilities

($ 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

1

1

Commodity contracts

5

Interest rate contracts

41

4

Cash-settled call options

25

16

Total

31

57

5

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

Foreign exchange contracts

134

24

183

62

Commodity contracts

31

1

7

Cross-currency interest rate swaps

2

Cash-settled call options

1

Embedded foreign exchange derivatives

15

10

15

3

Total

180

36

207

65

Total fair value

211

93

207

70

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, 2018 and 2017, have been presented on a gross basis.

The Company’s netting agreements and other similar arrangements allow net settlements under certain conditions. At December 31, 2018 and 2017, information related to these offsetting arrangements was as follows:

December 31, 2018 ($ in millions)

Type of agreement or similar arrangement

Gross amount of recognized assets

Derivative liabilities eligible for set-off in case of default

Cash collateral received

Non-cash collateral received

Net asset exposure

Derivatives

181

(121)

60

Reverse repurchase agreements

206

(206)

Total

387

(121)

(206)

60

December 31, 2018 ($ in millions)

Type of agreement or similar arrangement

Gross amount of recognized
liabilities

Derivative liabilities
eligible for set-off in case of default

Cash collateral
pledged

Non-cash collateral
pledged

Net liability
exposure

Derivatives

220

(121)

99

Total

220

(121)

99

December 31, 2017 ($ in millions)

Type of agreement or similar arrangement

Gross amount of recognized
assets

Derivative liabilities
eligible for set-off in case of default

Cash collateral
received

Non-cash collateral
received

Net asset
exposure

Derivatives

279

(167)

112

Reverse repurchase agreements

305

(305)

Total

584

(167)

(305)

112

December 31, 2017 ($ in millions)

Type of agreement or similar arrangement

Gross amount of recognized
liabilities

Derivative liabilities
eligible for set-off in case of default

Cash collateral
pledged

Non-cash collateral
pledged

Net liability
exposure

Derivatives

259

(167)

92

Total

259

(167)

92