Estee Lauder 2014 Annual Report Download - page 69

THE EST{E LAUDER COMPANIES INC. 67
document all relationships between hedging instruments
and hedged items, as well as our risk-management
objective and strategy for undertaking the hedge transac-
tion, the nature of the risk being hedged, how the hedg-
ing instruments’ effectiveness in offsetting the hedged
risk will be assessed prospectively and retrospectively,
and a description of the method of measuring ineffective-
ness. This process includes linking all derivatives to spe-
cific assets and liabilities on the balance sheet or to
specific firm commitments or forecasted transactions.
We also formally assess, both at the hedge’s inception
and on an ongoing basis, whether the derivatives that are
used in hedging transactions are highly effective in offset-
ting 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 effective 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 where there is a high probability
that anticipated exposures will materialize. The foreign
currency forward contracts entered into to hedge antici-
pated transactions have been designated as foreign cur-
rency cash-flow hedges and have varying maturities
through the end of June 2016. Hedge effectiveness of
foreign currency forward contracts is based on a hypo -
thetical derivative methodology and excludes the portion
of fair value attributable to the spot-forward difference
which is recorded in current-period earnings. Hedge
effectiveness of foreign currency option contracts is
based on a dollar offset methodology. The ineffective por-
tion of both foreign currency forward and option con-
tracts 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 underlying 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,
2014, these foreign currency cash-flow hedges were
highly effective in all material respects.
At June 30, 2014, we had foreign currency forward
contracts in the amount of $1,597.3 million. The foreign
currencies included in foreign currency forward contracts
(notional value stated in U.S. dollars) are principally the
British pound ($267.2 million), Euro ($239.8 million),
Swiss franc ($170.4 million), Canadian dollar ($138.6
million), Australian dollar ($111.3 million), Japanese yen
($108.0 million) and Hong Kong dollar ($103.0 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 contracts
in asset positions, which totaled $4.2 million at June 30,
2014. To manage this risk, we have established strict
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, with
two counterparties, contain credit-risk-related contingent
features. At June 30, 2014, we were in a net liability posi-
tion for certain derivative contracts that contain such fea-
tures. Such credit-risk-related contingent features would
be triggered if (a) upon a merger involving the Company,
the ratings of the surviving entity were materially weaker
than prior to the merger or (b) the Company’s credit rat-
ings fall below investment grade (rated below BBB-/Baa3)
and the Company fails to enter into an International
Swaps & Derivatives Association Credit Support Annex
within 30 days of being requested by the counterparty.
The fair value of collateral required to settle the instru-
ments immediately if a triggering event were to occur is
estimated at approximately the fair value of the contracts.
The fair value of those contracts as of June 30, 2014 was
$4.5 million. As of June 30, 2014, we were in compliance
with such credit-risk-related contingent features.
Market Risk
We use a value-at-risk model to assess the market risk of
our derivative financial instruments. Value-at-risk
represents the potential losses for an instrument or port-
folio from adverse changes in market factors for a speci-
fied time period and confidence level. We estimate
value-at-risk across all of our derivative financial instru-
ments using a model with historical volatilities and