Alcoa 2009 Annual Report Download - page 147

These embedded derivatives are primarily valued using observable market prices. However, due to the length of the
contracts, the valuation model also requires management to estimate the long-term price of aluminum based upon
anticipated changes in worldwide supply and demand. The embedded derivatives have been designated as hedges of
forward sales of aluminum and their realized gains and losses were included in Sales on the accompanying Statement
of Consolidated Operations.
Also, included within Level 3 measurements are derivative financial instruments that hedge the cost of electricity.
Transactions involving on-peak power are observable as there is an active market. However, there are certain off-peak
times when there is not an actively traded market for electricity. Therefore, management utilizes various forecast
services, historical relationships, and near term market actual pricing to determine the fair value. Gains and losses
realized for the financial electricity contracts were included in Cost of goods sold on the accompanying Statement of
Consolidated Operations. In 2009, an existing power contract associated with a smelter in the U.S. no longer qualified
for the normal purchase normal sale exception under derivative accounting. Management utilizes a similar valuation
technique as those used to value the hedge of electricity. Gains and losses realized for physical power contracts are
included in Other income, net on the accompanying Statement of Consolidated Operations.
Additionally, an embedded derivative in a power contract that indexes the difference between the long-term debt
ratings of Alcoa and the counterparty from any of the three major credit rating agencies is included in Level 3.
Management uses forecast services, historical relationships, and market prices to determine fair value. Realized gains
and losses for this embedded derivative were included in Other income, net on the accompanying Statement of
Consolidated Operations. None of the Level 3 positions on hand at December 31, 2009 and 2008 resulted in any
unrealized gains in the accompanying Statement of Consolidated Operations.
Fair Value Hedges
For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the derivative as well
as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings.
Alcoa includes the gain or loss on the hedged items in the same line items as the offsetting loss or gain on the related
derivative contracts as follows (there were no contracts that ceased to qualify as a fair value hedge in 2009, 2008, or
2007):
Derivatives in Fair Value Hedging
Relationships
Location of Gain or (Loss)
Recognized in Income on Derivatives
Amount of Gain or (Loss)
Recognized in Income on Derivatives
2009 2008 2007
Aluminum contracts Sales $214 $(539) $(161)
Interest rate contracts Interest expense 61 16 26
Foreign exchange contracts Other income, net – (1) 8
Total $275 $(524) $(127)
Aluminum. Alcoa is a leading global producer of primary aluminum and fabricated aluminum products. As a
condition of sale, customers often require Alcoa to enter into long-term, fixed-price commitments. These commitments
expose Alcoa to the risk of fluctuating aluminum prices between the time the order is committed and the time that the
order is shipped. Alcoa’s aluminum commodity risk management policy is to manage, principally through the use of
futures and options contracts, the aluminum price risk associated with a portion of its firm commitments. These
contracts cover known exposures, generally within three years. As of December 31, 2009, Alcoa had 440 kmt of
aluminum futures designated as fair value hedges. The effects of this hedging activity will be recognized over the
designated hedge periods in 2010 to 2012.
Interest Rates. Alcoa uses interest rate swaps to help maintain a strategic balance between fixed- and floating-rate
debt and to manage overall financing costs. As of December 31, 2009 the Company had pay floating, receive fixed
interest rate swaps that were designated as fair value hedges. These hedges effectively convert the interest rate from
fixed to floating on $1,890 of debt through 2018 (see Note K).
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