IBM 2004 Annual Report Download - page 68

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
International Business Machines Corporation and Subsidiary Companies
66
ibm annual report 2004
long-term investments in foreign subsidiaries (net investment)
A significant portion of the company’s foreign currency denominated debt portfolio is
designated as a hedge of net investment to reduce the volatility in stockholders’ equity
caused by changes in foreign currency exchange rates in the functional currency of major
foreign subsidiaries with respect to the U.S. dollar. The company also uses currency swaps
and foreign exchange forward contracts for this risk management purpose. The currency
effects of these hedges (approximately $156 million in 2004 and approximately $200 mil-
lion in 2003, net of tax) are reflected as a loss in the Accumulated gains and (losses) not
affecting retained earnings section of the Consolidated Statement of Stockholders’ Equity,
thereby offsetting a portion of the translation adjustment of the applicable foreign sub-
sidiaries’ net assets.
anticipated royalties and cost transactions
The company’s operations generate significant nonfunctional currency, third-party vendor
payments and intercompany payments for royalties, and goods and services among the
company’s non-U.S. subsidiaries and with the parent company. In anticipation of these
foreign currency cash flows and in view of the volatility of the currency markets, the com-
pany selectively employs foreign exchange forward and option contracts to manage its
currency risk. In general, these hedges have maturities of one year or less, but from time
to time extend beyond one year commensurate with the underlying hedged anticipated
cash flow. At December 31, 2004, the weighted-average remaining maturity of these
derivative instruments was approximately one year.
subsidiary cash and foreign currency asset/liability management
The company uses its Global Treasury Centers to manage the cash of its subsidiaries.
These centers principally use currency swaps to convert cash flows in a cost-effective
manner. In addition, the company uses foreign exchange forward contracts to hedge, on
a net basis, the foreign currency exposure of a portion of the company’s nonfunctional cur-
rency assets and liabilities. The terms of these forward and swap contracts are generally
less than one year. The changes in fair value from these contracts and from the underlying
hedged exposures are generally offsetting and are recorded in Other (income) and
expense in the Consolidated Statement of Earnings.
equity risk management
The company is exposed to certain equity price changes related to certain obligations to
employees. These equity exposures are primarily related to market value movements in
certain broad equity market indices and in the company’s own stock. Changes in the over-
all value of this employee compensation obligation are recorded in SG&A expense in the
Consolidated Statement of Earnings. Although not designated as accounting hedges, the
company utilizes equity derivatives, including equity swaps and futures to economically
hedge the equity exposures relating to this employee compensation obligation. To match
the exposures relating to this employee compensation obligation, these derivatives are
linked to the total return of certain broad equity market indices and/or the total return of
the company’s common stock. These derivatives are recorded at fair value with gains or
losses also reported in SG&A expense in the Consolidated Statement of Earnings.
other derivatives
The company holds warrants in connection with certain investments that, although not
designated as hedging instruments, are deemed derivatives since they contain net share
settlement clauses. During the year, the company recorded the change in the fair value of
these warrants in net income.
The company is exposed to a potential loss if a client fails to pay amounts due the
company under contractual terms (“credit risk”). The company has established policies and
procedures for mitigating credit risk on principal transactions, including reviewing and estab-
lishing limits for credit exposure, maintaining collateral, and continually assessing the credit-
worthiness of counterparties. Master agreements with counterparties include master netting
arrangements as further mitigation of credit exposure to counterparties. These arrangements
permit the company to net amounts due from the company to a counterparty with amounts
due to the company from a counterparty reducing the maximum loss from credit risk in the
event of counterparty default. Also, in 2003, the company began utilizing credit default swaps
to economically hedge certain credit exposures. These derivatives have terms of two years.
The swaps are not designated as accounting hedges and are recorded at fair value with
gains and losses reported in SG&A expense in the Consolidated Statement of Earnings.
The following table and the table on page 67 summarize the net fair value of the
company’s derivative and other risk management instruments at December 31, 2004 and
2003 (included in the Consolidated Statement of Financial Position).
risk management program
(Dollars in millions)
Hedge Designation
Net Non-Hedge/
AT DECEMBER 31, 2004 Fair Value Cash Flow Investment Other
Derivatives—net asset/(liability):
Debt risk management $«221 $«««(53) $«««««««— $«(14)
Long-term investments in foreign
subsidiaries (net investments) — — (58) —
Anticipated royalties and
cost transactions — (939) — —
Subsidiary cash and foreign currency
asset/liability management — — — (19)
Equity risk management ——— (7)
Total derivatives 221(a) (992) (b) (58) (c) (40) (d)
Debt:
Long-term investments in foreign
subsidiaries (net investments) — — (2,490) (e) —
Total $«221 $«(992) $«(2,548) $«(40)
(a) Comprises assets of $440 million and liabilities of $219 million.
(b) Comprises assets of $12 million and liabilities of $1,004 million.
(c) Comprises liabilities of $58 million.
(d) Comprises assets of $60 million and liabilities of $100 million.
(e) Represents fair value of foreign denominated debt issuances formally designated as a hedge of net investment.