UPS 2004 Annual Report Download - page 70

68 UPS Annual Report 2004
Notes to consolidated financial statements
NOTE 16. DERIVATIVE INSTRUMENTS AND RISK MANAGEMENT
We are exposed to market risk, primarily related to foreign
exchange rates, commodity prices, equity prices, and interest rates.
These exposures are actively monitored by management. To man-
age 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 cur-
rency rates, commodity prices, equity 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.
Commodity Price Risk Management
We are exposed to an increase in the prices of refined fuels, prin-
cipally jet-A, diesel, and unleaded gasoline. Additionally, we are
exposed to an increase in the prices of other energy products,
principally natural gas and electricity. We use a combination of
options, swaps, and futures contracts to provide partial protec-
tion from rising fuel and energy prices. The net fair value of such
contracts subject to price risk, excluding the underlying expo-
sures, as of December 31, 2004 and 2003 was an asset of $101
and $30 million, respectively. We have designated and account
for these contracts as cash flow hedges, and, therefore, the
resulting gains and losses from these hedges are recognized as a
component of fuel expense or other occupancy expense when the
underlying fuel or energy product being hedged is consumed.
Foreign Currency Exchange Risk Management
We have foreign currency risks related to our revenue, operating
expenses, and financing transactions in currencies other than the
local currencies in which we operate. We are exposed to cur-
rency risk from the potential changes in functional currency
values of our foreign currency denominated assets, liabilities,
and cash flows. Our most significant foreign currency exposures
relate to the Euro, the British Pound Sterling, and the Canadian
Dollar. We use a combination of purchased and written options
and forward contracts to hedge currency cash flow exposures.
As of December 31, 2004 and 2003, the net fair value of the
hedging instruments described above was a liability of $(28) and
$(48) million, respectively. We have designated and account for
these contracts as cash flow hedges of anticipated foreign cur-
rency denominated revenue and, therefore, the resulting gains
and losses from these hedges are recognized as a component of
international revenue when the underlying sales occur.
Interest Rate Risk Management
Our indebtedness under our various financing arrangements cre-
ates interest rate risk. We use a combination of derivative
instruments, including interest rate swaps and cross-currency
interest rate swaps, 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. These swaps are entered into
concurrently with the issuance of the debt that they are intended
to modify, and the notional amount, interest payment, and
maturity dates of the swaps match the terms of the associated
debt. Interest rate swaps allow us to maintain a target range of
floating rate debt.
We have designated and account for these contracts as either
hedges of the fair value of the associated debt instruments, or as
hedges of the variability in expected future interest payments.
Any periodic settlement payments are accrued monthly, as
either a charge or credit to interest expense, and are not mate-
rial to net income. The net fair value of our interest rate swaps
at December 31, 2004 and 2003 was a liability of $(32) and
$(27) million, respectively.
Credit Risk Management
The forward contracts, swaps, and options previously discussed
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 counterpar-
ties to large banks and financial institutions that meet established
credit guidelines. We do not expect to incur any losses as a result
of counterparty default.