Alcoa 2012 Annual Report Download - page 160

information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad
levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities
(Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are
described below:
• Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for
identical, unrestricted assets or liabilities.
• Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability,
either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted
prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted
prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally
from or corroborated by observable market data by correlation or other means.
• Level 3—Inputs that are both significant to the fair value measurement and unobservable.
The following section describes the valuation methodologies used by Alcoa to measure derivative contracts at fair
value, including an indication of the level in the fair value hierarchy in which each instrument is generally classified.
Where appropriate, the description includes details of the valuation models, the key inputs to those models, and any
significant assumptions. These valuation models are reviewed and tested at least on an annual basis.
Derivative contracts are valued using quoted market prices and significant other observable and unobservable inputs.
Such financial instruments consist of aluminum, energy, interest rate, and foreign exchange contracts. The fair values
for the majority of these derivative contracts are based upon current quoted market prices. These financial instruments
are typically exchange-traded and are generally classified within Level 1 or Level 2 of the fair value hierarchy
depending on whether the exchange is deemed to be an active market or not.
For certain derivative contracts whose fair values are based upon trades in liquid markets, such as interest rate swaps,
valuation model inputs can generally be verified through over-the-counter markets and valuation techniques do not
involve significant management judgment. The fair values of such financial instruments are generally classified within
Level 2 of the fair value hierarchy.
Alcoa has other derivative contracts that do not have observable market quotes. For these financial instruments,
management uses significant other observable inputs (e.g., information concerning time premiums and volatilities for
certain option type embedded derivatives and regional premiums for aluminum contracts). For periods beyond the term
of quoted market prices for aluminum, Alcoa uses a model that estimates the long-term price of aluminum by
extrapolating the 10-year London Metal Exchange (LME) forward curve. For periods beyond the term of quoted
market prices for energy, management has developed a forward curve based on independent consultant market
research. Where appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads, and credit
considerations. Such adjustments are generally based on available market evidence (Level 2). In the absence of such
evidence, management’s best estimate is used (Level 3). If a significant input that is unobservable in one period
becomes observable in a subsequent period, the related asset or liability would be transferred to the appropriate level
classification (1 or 2) in the period of such change.
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