Quarterly report pursuant to Section 13 or 15(d)

DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT

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DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT
 9 Months Ended
Sep. 30, 2015
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT
DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT
Risk Management Policies
We are exposed to market risk, primarily related to foreign exchange rates, commodity prices and interest rates. These exposures are actively monitored by management. To manage the volatility relating to certain of these exposures, we enter into a variety of derivative financial instruments. Our objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in foreign currency rates, commodity prices and interest rates. It is our policy and practice to use derivative financial instruments only to the extent necessary to manage exposures. As we use price sensitive instruments to hedge a certain portion of our existing and anticipated transactions, we expect that any loss in value for those instruments generally would be offset by increases in the value of those hedged transactions. We do not hold or issue derivative financial instruments for trading or speculative purposes.
Credit Risk Management
The forward contracts, swaps and options discussed below contain an element of risk that the counterparties may be unable to meet the terms of the agreements; however, we minimize such risk exposures for these instruments by limiting the counterparties to banks and financial institutions that meet established credit guidelines, and by monitoring counterparty credit risk to prevent concentrations of credit risk with any single counterparty.
 We have agreements with all of our active counterparties (covering the majority of our derivative positions) containing early termination rights and/or zero threshold bilateral collateral provisions whereby cash is required based on the net fair value of derivatives associated with those counterparties. Events such as a counterparty credit rating downgrade (depending on the ultimate rating level) could also allow us to take additional protective measures such as the early termination of trades. At September 30, 2015 and December 31, 2014, we held cash collateral of $737 and $548 million, respectively, under these agreements; this collateral is included in "cash and cash equivalents" on the consolidated balance sheets and its use by UPS is not restricted.
In connection with the zero threshold bilateral collateral provisions described above, we were required to post $0 and $1 million in collateral with our counterparties as of September 30, 2015 and December 31, 2014, respectively. As of those dates, there were no instruments in a net liability position that were not covered by the zero threshold bilateral collateral provisions. Additionally, in connection with the agreements described above, we could be required to terminate transactions with certain counterparties in the event of a downgrade of our credit rating.
We have not historically incurred, and do not expect to incur in the future, any losses as a result of counterparty default.
Accounting Policy for Derivative Instruments
We recognize all derivative instruments as assets or liabilities in the consolidated balance sheets at fair value. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the derivative, based upon the exposure being hedged, as a cash flow hedge, a fair value hedge or a hedge of a net investment in a foreign operation.
A cash flow hedge refers to hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of AOCI, and reclassified into earnings in the same period during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, or hedge components excluded from the assessment of effectiveness, are recognized in the statements of consolidated income during the current period.
A fair value hedge refers to hedging the exposure to changes in the fair value of an existing asset or liability on the consolidated balance sheets that is attributable to a particular risk. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument is recognized in the statements of consolidated income during the current period, as well as the offsetting gain or loss on the hedged item.
A net investment hedge refers to the use of cross currency swaps, forward contracts or foreign currency denominated debt to hedge portions of our net investments in foreign operations. For hedges that meet the effectiveness requirements, the net gains or losses attributable to changes in spot exchange rates are recorded in the cumulative translation adjustment within AOCI. The remainder of the change in value of such instruments is recorded in earnings.
Types of Hedges
Commodity Risk Management
Currently, the fuel surcharges that we apply to our domestic and international package and LTL services are the primary means of reducing the risk of adverse fuel price changes on our business. We periodically enter into option contracts on energy commodity products to manage the price risk associated with forecasted transactions involving refined fuels, principally jet-A, diesel and unleaded gasoline. The objective of the hedges is to reduce the variability of cash flows, due to changing fuel prices, associated with the forecasted transactions involving those products. We have designated and account for these contracts as cash flow hedges of the underlying forecasted transactions involving these fuel products and, therefore, the resulting gains and losses from these hedges are recognized as a component of fuel expense or revenue when the underlying transactions occur.
Foreign Currency Risk Management
To protect against the reduction in value of forecasted foreign currency cash flows from our international package business, we maintain a foreign currency cash flow hedging program. Our most significant foreign currency exposures relate to the Euro, British Pound Sterling, Canadian Dollar, Chinese Renminbi and Hong Kong Dollar. We hedge portions of our forecasted revenue denominated in foreign currencies with option contracts. We have designated and account for these contracts as cash flow hedges of anticipated foreign currency denominated revenue and, therefore, the resulting gains and losses from these hedges are recognized as a component of international package revenue when the underlying sales transactions occur.
We also hedge portions of our anticipated cash settlements of intercompany transactions subject to foreign currency remeasurement using foreign currency forward contracts. We have designated and account for these contracts as cash flow hedges of forecasted foreign currency denominated transactions; therefore, the resulting gains and losses from these hedges are recognized as a component of other operating expense when the underlying transactions are subject to currency remeasurement.
Interest Rate Risk Management
Our indebtedness under our various financing arrangements creates interest rate risk. We use a combination of derivative instruments as part of our program to manage the fixed and floating interest rate mix of our total debt portfolio and related overall cost of borrowing. The notional amount, interest payment date and maturity date of the swaps match the terms of the associated debt being hedged. Interest rate swaps allow us to maintain a target range of floating rate debt within our capital structure.
We have designated and account for the majority of our interest rate swaps that convert fixed rate interest payments into floating rate interest payments as hedges of the fair value of the associated debt instruments. Therefore, the gains and losses resulting from fair value adjustments to the interest rate swaps and fair value adjustments to the associated debt instruments are recorded to interest expense in the period in which the gains and losses occur. We have designated and account for interest rate swaps that convert floating rate interest payments into fixed rate interest payments as cash flow hedges of the forecasted payment obligations. The gains and losses resulting from fair value adjustments to the interest rate swaps are recorded to AOCI.
We periodically hedge the forecasted fixed-coupon interest payments associated with anticipated debt offerings, using forward starting interest rate swaps, interest rate locks or similar derivatives. These agreements effectively lock a portion of our interest rate exposure between the time the agreement is entered into and the date when the debt offering is completed, thereby mitigating the impact of interest rate changes on future interest expense. These derivatives are settled commensurate with the issuance of the debt, and any gain or loss upon settlement is amortized as an adjustment to the effective interest yield on the debt.
Outstanding Positions
As of September 30, 2015 and December 31, 2014, the notional amounts of our outstanding derivative positions were as follows (in millions):
 
September 30, 2015
 
December 31, 2014
Currency hedges:
 
 
 
 
 
British Pound Sterling
GBP
1,223

 
GBP
1,149

Canadian Dollar
CAD
252

 
CAD
293

Euro
EUR
1,842

 
EUR
2,833

Indian Rupee
INR
205

 
INR
85

Malaysian Ringgit
MYR
—

 
MYR
150

Mexican Peso
MXN
2,571

 
MXN
152

 
 
 
 
 
 
Interest rate hedges:
 
 
 
 
 
Fixed to Floating Interest Rate Swaps
$
5,799

 
$
5,799

Floating to Fixed Interest Rate Swaps
$
779

 
$
779

Interest Rate Basis Swaps
$
—

 
$
1,500

 
 
 
 
 
 
Investment market price hedges:
 
 
 
 
 
Marketable Securities
EUR
251

 
EUR
—



Balance Sheet Recognition and Fair Value Measurements
The following table indicates the location on the consolidated balance sheets in which our derivative assets and liabilities have been recognized, the fair value hierarchy level applicable to each derivative type and the related fair values of those derivatives (in millions). The table is segregated between those derivative instruments that qualify and are designated as hedging instruments and those that are not, as well as by type of contract and whether the derivative is in an asset or liability position.
We have master netting arrangements with substantially all of our counterparties giving us the right of offset for our derivative positions. However, we have not elected to offset the fair value positions of our derivative contracts recorded on our consolidated balance sheets. The columns labeled "Net Amounts if Right of Offset had been Applied" indicate the potential net fair value positions by type of contract and location on the consolidated balance sheets had we elected to apply the right of offset.
 
 
 
Fair Value Hierarchy Level
 
Gross Amounts Presented in
Consolidated Balance Sheets
 
Net Amounts if Right of
Offset had been Applied
Asset Derivatives
Balance Sheet Location
 
 
September 30,
2015
 
December 31,
2014
 
September 30,
2015
 
December 31,
2014
Derivatives designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
Level 2
 
$
357

 
$
204

 
$
357

 
$
204

Foreign exchange contracts
Derivative assets
 
Level 2
 
109

 
229

 
109

 
229

Interest rate contracts
Derivative assets
 
Level 2
 
275

 
227

 
262

 
194

Derivatives not designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current assets
 
Level 2
 
5

 
2

 
5

 
2

Interest rate contracts
Derivative assets
 
Level 2
 
71

 
59

 
64

 
57

Total Asset Derivatives
 
 
 
 
$
817

 
$
721

 
$
797

 
$
686

 
 
 
 
 
 
 
 
 
 
 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value Hierarchy Level
 
Gross Amounts Presented in
Consolidated Balance Sheets
 
Net Amounts if Right of
Offset had been Applied
Liability Derivatives
Balance Sheet Location
 
 
September 30,
2015
 
December 31,
2014
 
September 30,
2015
 
December 31,
2014
Derivatives designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other non-current liabilities
 
Level 2
 
$
—

 
$
34

 
$
—

 
$
34

Interest rate contracts
Other non-current liabilities
 
Level 2
 
13

 
35

 
—

 
2

Derivatives not designated as hedges:
 
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
Other current liabilities
 
Level 2
 
3

 
—

 
3

 
—

Interest rate contracts
Other current liabilities
 
Level 2
 
—

 
1

 
—

 
1

Investment market price contracts
Other current liabilities
 
Level 2
 
36

 
—

 
36

 
—

Interest rate contracts
Other non-current liabilities
 
Level 2
 
25

 
7

 
18

 
5

Total Liability Derivatives
 
 
 
 
$
77

 
$
77

 
$
57

 
$
42


Our foreign currency, interest rate and investment market price derivatives are largely comprised of over-the-counter derivatives, which are primarily valued using pricing models that rely on market observable inputs such as yield curves, currency exchange rates and investment forward prices; therefore, these derivatives are classified as Level 2.
Income Statement and AOCI Recognition
The following table indicates the amount of gains and losses that have been recognized in AOCI for the three and nine months ended September 30, 2015 and 2014 for those derivatives designated as cash flow hedges (in millions):
Three Months Ended September 30:
 
 
 
 
Derivative Instruments in Cash Flow Hedging Relationships
 
Amount of Gain (Loss) Recognized in AOCI on Derivative (Effective Portion)
 
2015
 
2014
Interest rate contracts
 
$
(1
)
 
$
—

Foreign exchange contracts
 
44

 
277

Total
 
$
43

 
$
277

 
 
 
 
 
Nine Months Ended September 30:
 
 
 
 
Derivative Instruments in Cash Flow Hedging Relationships
 
Amount of Gain (Loss) Recognized in AOCI on Derivative (Effective Portion)
 
2015
 
2014
Interest rate contracts
 
$
(1
)
 
$
(3
)
Foreign exchange contracts
 
191

 
209

Total
 
$
190

 
$
206


As of September 30, 2015, $305 million of pre-tax gains related to cash flow hedges that are currently deferred in AOCI are expected to be reclassified to income over the 12 month period ended September 30, 2016. The actual amounts that will be reclassified to income over the next 12 months will vary from this amount as a result of changes in market conditions. The maximum term over which we are hedging exposures to the variability of cash flow is 17 years.
The amount of ineffectiveness recognized in income on derivative instruments designated in cash flow hedging relationships was immaterial for the three and nine months ended September 30, 2015 and 2014.
The following table indicates the amount and location in the statements of consolidated income in which derivative gains and losses, as well as the associated gains and losses on the underlying exposure, have been recognized for those derivatives designated as fair value hedges for the three and nine months ended September 30, 2015 and 2014 (in millions):
Derivative Instruments
in Fair Value
Hedging Relationships
Location of Gain (Loss) Recognized in Income
 
Derivative Amount of Gain (Loss) Recognized in Income
 
Hedged Items in
Fair Value
Hedging
Relationships
 
Location of 
Gain (Loss)
Recognized In
 Income
 
Hedged Items Amount of Gain (Loss)
Recognized in Income
 
2015
 
2014
 
 
 
2015
 
2014
Three Months Ended September 30:
 
 
 
 
 
 
 
Interest rate contracts
Interest Expense
 
$
80

 
$
(49
)
 
Fixed-Rate
Debt and
Capital Leases
 
Interest
Expense
 
$
(80
)
 
$
49

Nine Months Ended September 30:
 
 
 
 
 
 
 
 
 
 
Interest rate contracts
Interest
Expense
 
$
71

 
$
34

 
Fixed-Rate
Debt and
Capital Leases
 
Interest
Expense
 
$
(71
)
 
$
(34
)


Additionally, we maintain some interest rate swap, foreign currency forward, and investment market price forward contracts that are not designated as hedges. These interest rate swap contracts are intended to provide an economic hedge of a portfolio of interest bearing receivables. These foreign exchange forward contracts are intended to provide an economic offset to foreign currency remeasurement and settlement risk for certain assets and liabilities on our consolidated balance sheets. These investment market price forward contracts are intended to provide an economic offset to fair value fluctuations of certain investments in marketable securities.
We also periodically terminate interest rate swaps and foreign currency options by entering into offsetting swap and foreign currency positions with different counterparties. As part of this process, we de-designate our original swap and foreign currency contracts. These transactions provide an economic offset that effectively eliminate the effects of changes in market valuation.
The following is a summary of the amounts recorded in the statements of consolidated income related to fair value changes and settlements of these interest rate swaps, foreign currency forward and investment market price forward contracts not designated as hedges for the three and nine months ended September 30, 2015 and 2014 (in millions):
Derivative Instruments Not Designated in
Hedging Relationships
Location of Gain (Loss)
Recognized in Income
 
Amount of Gain (Loss)
Recognized in Income
 
2015
 
2014
Three Months Ended September 30:
 
 
 
 
 
Interest rate contracts
Interest Expense
 
$
(2
)
 
$
(1
)
Foreign exchange contracts
Other Operating Expenses
 
2

 
24

Foreign exchange contracts
Investment Income
 
14

 
(5
)
Foreign exchange contracts
Interest Expense
 
(30
)
 
—

Investment market price contracts
Investment Income
 
(27
)
 
—

 
 
 
$
(43
)
 
$
18

Nine Months Ended September 30:
 
 
 
 
 
Interest rate contracts
Interest Expense
 
$
(5
)
 
$
(4
)
Foreign exchange contracts
Other Operating Expenses
 
18

 
20

Foreign exchange contracts
Investment Income
 
49

 
(3
)
Foreign exchange contracts
Interest Expense
 
6

 
—

Investment market price contracts
Investment Income
 
(36
)
 
—

 
 
 
$
32

 
$
13