Estee Lauder 2012 Annual Report Download - page 122

120 THE EST{E LAUDER COMPANIES INC.
Derivative Financial Instruments and
Hedging Activities
We address certain financial exposures through a con-
trolled program of risk management that includes the use
of derivative financial instruments. We enter into foreign
currency forward contracts and may enter into option
contracts to reduce the effects of fluctuating foreign
currency exchange rates and interest rate derivatives to
manage the effects of interest rate movements on our
aggregate liability portfolio. We also enter into foreign
currency forward contracts and may use option contracts,
not designated as hedging instruments, to mitigate the
change in fair value of specific assets and liabilities on the
balance sheet. We do not utilize derivative financial
instruments for trading or speculative purposes. Costs
associated with entering into these derivative financial
instruments have not been material to our consolidated
financial results.
For each derivative contract entered into where we
look to obtain special hedge accounting treatment, we for-
mally document all relationships between hedging instru-
ments and hedged items, as well as our risk-management
objective and strategy for undertaking the hedge trans-
action, the nature of the risk being hedged, how the
hedging instruments’ effectiveness in offsetting the
hedged risk will be assessed prospectively and retro-
spectively, and a description of the method of measuring
ineffectiveness. This process includes linking all deriva-
tives to specific assets and liabilities on the balance sheet
or to specific firm commitments or forecasted trans-
actions. We also formally assess, both at the hedge’s
inception and on an ongoing basis, whether the deriva-
tives that are used in hedging transactions are highly
effective in offsetting changes in fair values or cash flows
of hedged items. If it is determined that a derivative is not
highly effective, or that it has ceased to be a highly effec-
tive hedge, we will be required to discontinue hedge
accounting with respect to that derivative prospectively.
Foreign Exchange Risk Management
We enter into foreign currency forward contracts to
hedge anticipated transactions, as well as receivables and
payables denominated in foreign currencies, for periods
consistent with our identified exposures. The purpose of
the hedging activities is to minimize the effect of foreign
exchange rate movements on costs and on the cash flows
that we receive from foreign subsidiaries. The majority of
foreign currency forward contracts are denominated in
currencies of major industrial countries. We may also
enter into foreign currency option contracts to hedge
anticipated transactions. The foreign currency forward
contracts entered into to hedge anticipated transactions
have been designated as foreign currency cash-flow
hedges and have varying maturities through the end of
March 2014. Hedge effectiveness of foreign currency
forward contracts is based on a hypothetical derivative
methodology and excludes the portion of fair value attrib-
utable to the spot-forward difference which is recorded in
current-period earnings. The ineffective portion of foreign
currency forward contracts is recorded in current-period
earnings. For hedge contracts that are no longer deemed
highly effective, hedge accounting is discontinued and
gains and losses accumulated in other comprehensive
income (loss) are reclassified to earnings when the under-
lying forecasted transaction occurs. If it is probable that
the forecasted transaction will no longer occur, then any
gains or losses in accumulated other comprehensive
income (loss) are reclassified to current-period earnings.
As of June 30, 2012, these foreign currency cash-flow
hedges were highly effective in all material respects.
At June 30, 2012, we had foreign currency forward
contracts in the amount of $1,476.0 million. The foreign
currencies included in foreign currency forward contracts
(notional value stated in U.S. dollars) are principally the
British pound ($376.7 million), Euro ($223.4 million),
Canadian dollar ($184.0 million), Swiss franc ($129.9 mil-
lion), Australian dollar ($106.5 million), Korean won
($75.1 million) and Thailand baht ($51.3 million).
Credit Risk
As a matter of policy, we only enter into derivative con-
tracts with counterparties that have a long-term credit rat-
ing of at least A- or higher by at least two nationally
recognized rating agencies. The counterparties to these
contracts are major financial institutions. Exposure to
credit risk in the event of nonperformance by any of the
counterparties is limited to the gross fair value of con-
tracts in asset positions, which totaled $17.7 million at
June 30, 2012. To manage this risk, we have established
counterparty credit guidelines that are continually moni-
tored. Accordingly, management believes risk of loss
under these hedging contracts is remote.
Certain of our derivative financial instruments contain
credit-risk-related contingent features. At June 30, 2012,
we were in a net asset position for certain derivative
contracts that contain such features with two counterpar-
ties. The fair value of those contracts as of June 30, 2012
was approximately $2.8 million. As of June 30, 2012, we
were in compliance with such credit-risk-related contin-
gent features.
Market Risk
We use a value-at-risk model to assess the market risk of
our derivative financial instruments. Value-at-risk repre-