UPS 2006 Annual Report Download - page 50

Download and view the complete annual report

Please find page 50 of the 2006 UPS annual report below. You can navigate through the pages in the report by either clicking on the pages listed below, or by using the keyword search tool below to find specific information within the annual report.

Page out of 111

  • 1
  • 2
  • 3
  • 4
  • 5
  • 6
  • 7
  • 8
  • 9
  • 10
  • 11
  • 12
  • 13
  • 14
  • 15
  • 16
  • 17
  • 18
  • 19
  • 20
  • 21
  • 22
  • 23
  • 24
  • 25
  • 26
  • 27
  • 28
  • 29
  • 30
  • 31
  • 32
  • 33
  • 34
  • 35
  • 36
  • 37
  • 38
  • 39
  • 40
  • 41
  • 42
  • 43
  • 44
  • 45
  • 46
  • 47
  • 48
  • 49
  • 50
  • 51
  • 52
  • 53
  • 54
  • 55
  • 56
  • 57
  • 58
  • 59
  • 60
  • 61
  • 62
  • 63
  • 64
  • 65
  • 66
  • 67
  • 68
  • 69
  • 70
  • 71
  • 72
  • 73
  • 74
  • 75
  • 76
  • 77
  • 78
  • 79
  • 80
  • 81
  • 82
  • 83
  • 84
  • 85
  • 86
  • 87
  • 88
  • 89
  • 90
  • 91
  • 92
  • 93
  • 94
  • 95
  • 96
  • 97
  • 98
  • 99
  • 100
  • 101
  • 102
  • 103
  • 104
  • 105
  • 106
  • 107
  • 108
  • 109
  • 110
  • 111

engage in speculative trading activities. In order to manage the risk arising from these exposures, we utilize a
variety of foreign exchange, interest rate, equity and commodity forward contracts, options, and swaps.
The following analysis provides quantitative information regarding our exposure to commodity price risk,
foreign currency exchange risk, interest rate risk, and equity price risk. We utilize valuation models to evaluate
the sensitivity of the fair value of financial instruments with exposure to market risk that assume instantaneous,
parallel shifts in exchange rates, interest rate yield curves, and commodity and equity prices. For options and
instruments with non-linear returns, models appropriate to the instrument are utilized to determine the impact of
market shifts. There are certain limitations inherent in the sensitivity analyses presented, primarily due to the
assumption that exchange rates change in a parallel fashion and that interest rates change instantaneously. In
addition, the analyses are unable to reflect the complex market reactions that normally would arise from the
market shifts modeled.
A discussion of our accounting policies for derivative instruments and further disclosures are provided in
Note 15 to the consolidated financial statements.
Commodity Price Risk
We are exposed to an increase in the prices of refined fuels, principally jet-A, diesel, and unleaded gasoline,
which are used in the transportation of packages. Additionally, we are exposed to an increase in the prices of
other energy products, primarily natural gas and electricity, used in our operating facilities throughout the world.
We use a combination of options, swaps, and futures contracts to provide some protection from rising fuel and
energy prices. These derivative instruments generally cover forecasted fuel and energy consumption for periods
of one to three years. The net fair value of such contracts subject to price risk, excluding the underlying
exposures, as of December 31, 2006 and 2005 was an asset of $10 and $192 million, respectively. The potential
loss in the fair value of these derivative contracts, assuming a hypothetical 10% adverse change in the underlying
commodity price, would be approximately $8 and $35 million at December 31, 2006 and 2005, respectively. This
amount excludes the offsetting impact of the price risk inherent in the physical purchase of the underlying
commodities.
In the second quarter of 2006, we terminated several energy derivatives and received $229 million in cash.
These derivatives were designated as hedges of forecasted cash outflows for purchases of fuel products. As these
derivatives maintained their effectiveness and qualified for hedge accounting, we anticipate that the gains
associated with these hedges will be recognized in income over the original term of the hedges through 2007.
Foreign Currency Exchange Risk
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 currency 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 cash
flow currency exposures. These derivative instruments generally cover forecasted foreign currency exposures for
periods up to one year. As of December 31, 2006 and 2005, the net fair value of the hedging instruments
described above was an asset of $30 and $52 million, respectively. The potential loss in fair value for such
instruments from a hypothetical 10% adverse change in quoted foreign currency exchange rates would be
approximately $183 and $65 million at December 31, 2006 and 2005, respectively. This sensitivity analysis
assumes a parallel shift in the foreign currency exchange rates. Exchange rates rarely move in the same direction.
The assumption that exchange rates change in a parallel fashion may overstate the impact of changing exchange
rates on assets and liabilities denominated in a foreign currency.
35