Union Pacific 2001 Annual Report Download - page 68

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42
gains from favorable movements. The Corporation uses interest rate swaps to manage its exposure to interest rate
changes. The purpose of these programs is to protect the Corporation's operating margins and overall profitability from
adverse fuel price changes or interest rate fluctuations.
The Corporation may also use fuel swaptions to secure more favorable swap prices. Swaptions are swaps that are
extendable past their base period at the option of the counterparty. Swaptions do not qualify for hedge accounting
treatment and are marked-to-market through the Consolidated Statements of Income.
Market and Credit Risk – The Corporation addresses market risk related to derivative financial instruments by selecting
instruments whose value fluctuations highly correlate with the underlying item being hedged. Credit risk related to
derivative financial instruments, which is minimal, is managed by requiring high credit standards for counterparties and
periodic settlements. The Corporation has not been required to provide collateral; however, the Corporation may receive
collateral relating to its hedging activity where the concentration of credit risk was substantial.
In addition, the Corporation enters into secured financings in which the debtor has pledged collateral. The collateral
is based upon the nature of the financing and the credit risk of the debtor. The Corporation generally is not permitted
to sell or repledge the collateral unless the debtor defaults.
Determination of Fair Value – The fair values of the Corporation’s derivative financial instrument positions at December
31, 2001 and 2000, were determined based upon current fair values as quoted by recognized dealers or developed based
upon the present value of expected future cash flows discounted at the applicable U.S. Treasury rate, London Interbank
Offered Rates (LIBOR) or swap spread.
Interest Rate Strategy – The Corporation manages its overall exposure to fluctuations in interest rates by adjusting the
proportion of fixed- and floating-rate debt instruments within its debt portfolio over a given period. The mix of fixed-
and floating-rate debt is largely managed through the issuance of targeted amounts of each as debt matures or as
incremental borrowings are required. Derivatives are used in limited circumstances as one of the tools to obtain the
targeted mix and hedge the exposure to fair value changes. In addition, the Corporation obtains additional flexibility
in managing interest costs and the interest rate mix within its debt portfolio by issuing callable fixed-rate debt securities.
In May and August 2001, the Corporation entered into interest rate swaps on a total of $598 million of debt with
varying maturity dates extending to November 2004. The swaps allowed the Corporation to convert the debt from fixed
rates to variable rates and thereby hedge the risk of changes in the debt's fair value attributable to the changes in the
benchmark interest rate (LIBOR). The swaps have been accounted for using the short-cut method as allowed by FAS 133;
and therefore, no ineffectiveness has been recorded within the Corporation's Consolidated Financial Statements.
Fuel Strategy – As a result of the significance of the Corporation's fuel costs and the historical volatility of fuel prices, the
Corporation’s transportation subsidiaries periodically use swaps, futures and/or forward contracts to mitigate adverse
fuel price changes. In addition, the Corporation at times may use fuel swaptions to secure more favorable swap prices.
The following is a summary of the Corporation’s derivative financial instruments at December 31, 2001 and 2000:
Millions, Except Percentages and Average Commodity Prices 2001 2000
Interest rate hedging:
Amount of debt hedged...................................................................................................... $ 598 -
Percentage of total debt portfolio....................................................................................... 7% -
Rail fuel hedging/swaptions:
Number of gallons hedged for 2001[a] ............................................................................... 407 101
Average price of 2001 hedges (per gallon) [b].................................................................... $0.66 $0.68
Number of gallons hedged for 2002[c] ............................................................................... 567 -
Average price of 2002 hedges outstanding (per gallon)[b]................................................ $0.56 -
Number of gallons hedged for 2003[d]............................................................................... 63 -
Average price of 2003 fuel consumption hedged (per gallon)[b]...................................... $0.56 -