Estee Lauder 2004 Annual Report Download - page 55

THE EST{E LAUDER COMPANIES INC.
utilize derivative financial instruments for trading or spec-
ulative purposes. At June 30, 2004, we had foreign cur-
rency contracts in the form of forward exchange contracts
and option contracts in the amount of $593.6 million
and $82.0 million, respectively. The foreign currencies
included in forward exchange contracts (notional value
stated in U.S. dollars) are principally the Euro ($122.6 mil-
lion), Swiss franc ($117.1 million), British pound ($72.8
million), Japanese yen ($66.7 million), South Korean won
($42.0 million), Canadian dollar ($41.7 million), and
Australian dollar ($33.7 million). The foreign currencies
included in the option contracts (notional value stated in
U.S. dollars) are principally the Euro ($34.1 million), British
pound ($25.4 million), and Swiss franc ($12.7 million).
Interest Rate Risk Management
We enter into interest rate derivative contracts to manage
the exposure to fluctuations of interest rates on our
funded and unfunded indebtedness, as well as cash invest-
ments, for periods consistent with the identified expo-
sures. All interest rate derivative contracts are with large
financial institutions rated as strong investment grade by a
major rating agency.
We have an interest rate swap agreement with a
notional amount of $250.0 million to effectively convert
fixed interest on the existing $250.0 million 6% Senior
Notes to variable interest rates based on six-month LIBOR.
We designated the swap as a fair value hedge. As of June
30, 2004, the fair value hedge was highly effective, in all
material respects.
Additionally, in May 2003, in connection with the antic-
ipated issuance of debt, we entered into a series of treas-
ury lock agreements on a notional amount totaling
$195.0 million at a weighted average all-in rate of 4.53%.
These treasury lock agreements were used to hedge the
exposure to a possible rise in interest rates prior to the
September 2003 issuance of debt. The agreements were
settled upon the issuance of the $200.0 million of 5.75%
Senior Notes and we realized a gain in other comprehen-
sive income of $15.0 million that is currently being amor-
tized against interest expense over the 30-year life of the
5.75% Senior Notes.
Market Risk
We use a value-at-risk model to assess the market risk of
our derivative financial instruments. Value-at-risk repre-
sents the potential losses for an instrument or portfolio
from adverse changes in market factors for a specified
time period and confidence level. We estimate value-at-
risk across all of our derivative financial instruments using
a model with historical volatilities and correlations
calculated over the past 250-day period. The measured
value-at-risk, calculated as an average, for the twelve
months ended June 30, 2004 related to our foreign
exchange contracts and our interest rate contracts was
$9.5 million and $14.5 million, respectively. The model
estimates were made assuming normal market conditions
and a 95 percent confidence level. We used a statistical
simulation model that valued our derivative financial
instruments against one thousand randomly generated
market price paths.
Our calculated value-at-risk exposure represents an
estimate of reasonably possible net losses that would be
recognized on our portfolio of derivative financial instru-
ments assuming hypothetical movements in future mar-
ket rates and is not necessarily indicative of actual results,
which may or may not occur. It does not represent the
maximum possible loss or any expected loss that may
occur, since actual future gains and losses will differ from
those estimated, based upon actual fluctuations in mar-
ket rates, operating exposures, and the timing thereof, and
changes in our portfolio of derivative financial instruments
during the year.
We believe, however, that any loss incurred would be
offset by the effects of market rate movements on the
respective underlying transactions for which the hedge
is intended.
OFF-BALANCE SHEET ARRANGEMENTS
We do not maintain any off-balance sheet arrangements,
transactions, obligations or other relationships with uncon-
solidated entities that would be expected to have a mate-
rial current or future effect upon our financial condition or
results of operations.
RECENTLY ISSUED ACCOUNTING STANDARDS
On May 19, 2004, the Financial Accounting Standards
Board (“FASB”) issued FASB Staff Position No. FAS 106-2,
“Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modern-
ization Act of 2003” (“FSP No. 106-2”), in response to a
new law regarding prescription drug benefits under
Medicare (“Medicare Part D”) and a Federal subsidy to
sponsors of retiree health care benefit plans that provide
a benefit that is at least actuarially equivalent to Medicare
Part D. Currently, Statement of Financial Accounting Stan-
dard No. 106, “Employers’ Accounting for Postretirement
Benefits Other Than Pensions” (“SFAS No. 106”), requires
that changes in relevant law be considered in current
measurement of postretirement benefit costs. FSP
No. 106-2 will be effective for financial statements of
companies for the first interim or annual period beginning
after June 15, 2004. We will adopt FSP No. 106-2 in the
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