The Gap 2006 Annual Report Download - page 48

Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We operate in foreign countries, which exposes us to market risk associated with foreign currency exchange
rate fluctuations. Our risk management policy is to hedge substantially all forecasted merchandise purchases for
foreign operations using foreign exchange forward contracts. We also use forward contracts to hedge our market
risk exposure associated with foreign currency exchange rate fluctuations for certain intercompany loans and
balances denominated in currencies other than the functional currency of the entity holding or issuing the
intercompany loan or balance. These contracts are entered into with large, reputable financial institutions,
thereby minimizing the credit exposure from our counter-parties. The principal currencies hedged during fiscal
2006 were the Euro, British pound, Japanese yen, and Canadian dollar. Our use of derivative financial
instruments represents risk management; we do not use derivative financial instruments for trading purposes.
Additional information is presented in Note 6 of Notes to the Consolidated Financial Statements.
We have performed a sensitivity analysis as of February 3, 2007 and January 28, 2006, based on a model
that measures the change in fair values of our derivative financial instruments arising from a hypothetical 10
percent adverse change in the level of foreign currency exchange rates relative to the U.S. dollar with all other
variables held constant. The analysis covers all foreign exchange derivative financial instruments offset by the
underlying exposures. The foreign currency exchange rates used in the model were based on the spot rates in
effect at February 3, 2007 and January 28, 2006. The sensitivity analysis indicated that a hypothetical 10 percent
adverse movement in foreign currency exchange rates would have had an unfavorable impact on the fair values
of our foreign exchange derivative financial instruments, net of the underlying exposures, of $20 million at
February 3, 2007 and $30 million at January 28, 2006.
We hedge the net assets of certain international subsidiaries to offset the translation and economic exposures
related to our investments in these subsidiaries. The change in fair value of the hedging instrument is reported in
accumulated other comprehensive earnings (loss) within stockholders’ equity to offset the foreign currency
translation adjustments on the investments.
In addition, we used a cross-currency interest rate swap to swap the interest and principal payable of
$50 million debt securities of our Japanese subsidiary, Gap (Japan) KK, from a fixed interest rate of 6.25 percent,
payable in U.S. dollars, to 6.1 billion Japanese yen with a fixed interest rate of 2.43 percent. These debt securities
are recorded on the Consolidated Balance Sheets at their issuance amount, net of unamortized discount. The
derivative instruments are recorded in the Consolidated Balance Sheets at their fair value as of February 3, 2007.
We have limited exposure to interest rate fluctuations on our borrowings. The interest on our long-term debt
is set at a fixed coupon, with the exception of the interest rates payable by us on our outstanding $500 million
notes due December 2008, of which only $138 million remains outstanding, which are subject to change based
on our long-term senior secured credit ratings. The interest rates earned on our cash and equivalents will fluctuate
in line with short-term interest rates.
In March 2002, we issued $1.4 billion aggregate principal amount of 5.75 percent senior convertible notes
due March 15, 2009 (the “2009 Notes”), and received proceeds of $1.4 billion in cash, net of underwriting and
other fees. On March 11, 2005, we called for the full redemption of the 2009 Notes. The redemption was
complete by March 31, 2005. Note holders had the option to receive cash at a redemption price equal to 102.46
percent of the principal amount of the 2009 Notes, plus accrued interest, for a total of approximately $1,027 per
$1,000 principal amount of the 2009 Notes. Alternatively, note holders could elect to convert their 2009 Notes
into approximately 62.03 shares of The Gap, Inc. common stock per $1,000 principal amount. As of March 31,
2005, $1.4 billion of principal was converted into 85 million shares of The Gap, Inc. common stock and
approximately $0.5 million was paid in cash redemption.
In November 2001, we issued $500 million aggregate principal amount of debt securities at an original
annual interest rate of 8.80 percent, due December 15, 2008 (“2008 Notes”). Interest on the notes is payable
32