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Table of Contents
flows. This also has the effect of delaying the impact of current market rates on our consolidated financial statements dependent upon hedge horizons. We
use forward exchange contracts and options to hedge certain anticipated but not yet firmly committed transactions as well as certain firm commitments and
the related receivables and payables, including third party and intercompany transactions. We also use forward contracts to hedge our investment in the net
assets of certain international subsidiaries to offset foreign currency translation adjustments related to our net investment in those subsidiaries.
When we begin hedging exposures, the type and duration of each hedge depends on the nature of the exposure and market conditions. Generally, all
anticipated and firmly committed transactions that are hedged are to be recognized within 12 to 18 months. The majority of the contracts expiring in more
than 12 months relate to the anticipated purchase of inventory. When intercompany loans are hedged, it is typically for their expected duration. Hedged
transactions are principally denominated in Euros, Japanese Yen and British Pounds. See Section “Foreign Currency Exposures and Hedging Practices”
under Item 7 for additional detail.
Our earnings are also exposed to movements in short and long−term market interest rates. Our objective in managing this interest rate exposure is to
limit the impact of interest rate changes on earnings and cash flows and to reduce overall borrowing costs. To achieve these objectives, we maintain a mix
of commercial paper, bank loans and fixed rate debt of varying maturities and have entered into receive−fixed, pay−variable interest rate swaps.
Market Risk Measurement
We monitor foreign exchange risk, interest rate risk and related derivatives using a variety of techniques including a review of market value,
sensitivity analysis, and Value−at−Risk (“VaR”). Our market−sensitive derivative and other financial instruments are foreign currency forward contracts,
foreign currency option contracts, interest rate swaps, intercompany loans denominated in non−functional currencies, fixed interest rate U.S. dollar
denominated debt, and fixed interest rate Japanese Yen denominated debt.
We use VaR to monitor the foreign exchange risk of our foreign currency forward and foreign currency option derivative instruments only. The VaR
determines the maximum potential one−day loss in the fair value of these foreign exchange rate−sensitive financial instruments. The VaR model estimates
assume normal market conditions and a 95% confidence level. There are various modeling techniques that can be used in the VaR computation. Our
computations are based on interrelationships between currencies and interest rates (a “variance/co−variance” technique). These interrelationships are a
function of foreign exchange currency market changes and interest rate changes over the preceding one year period. The value of foreign currency options
does not change on a one−to−one basis with changes in the underlying currency rate. We adjusted the potential loss in option value for the estimated
sensitivity (the “delta” and “gamma”) to changes in the underlying currency rate. This calculation reflects the impact of foreign currency rate fluctuations on
the derivative instruments only and does not include the impact of such rate fluctuations on non−functional currency transactions (such as anticipated
transactions, firm commitments, cash balances, and accounts and loans receivable and payable), including those which are hedged by these instruments.
The VaR model is a risk analysis tool and does not purport to represent actual losses in fair value that we will incur, nor does it consider the potential
effect of favorable changes in market rates. It also does not represent the full extent of the possible loss that may occur. Actual future gains and losses will
differ from those estimated because of changes or differences in market rates and interrelationships, hedging instruments and hedge percentages, timing and
other factors.
The estimated maximum one−day loss in fair value on our foreign currency sensitive derivative financial instruments, derived using the VaR model,
was $17 million and $68 million at May 31, 2010 and 2009, respectively. The VaR decreased year−over−year as a result of reduced total notional value of
our foreign
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