Union Pacific 2002 Annual Report Download - page 56

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30
agreements with unions affiliated with the Teamsters. Although the agreements cover most of the employees at these two
facilities, less than half of these covered employees are actual members of unions.
Inflation – The cumulative effect of long periods of inflation has significantly increased asset replacement costs for capital-
intensive companies such as the Railroad, OTC and Motor Cargo. As a result, depreciation charges on an inflation-adjusted
basis, assuming that all operating assets are replaced at current price levels, would be substantially greater than historically
reported amounts.
Derivative Financial Instruments – The Corporation and its subsidiaries use derivative financial instruments in limited
instances for other than trading purposes to manage risk related to changes in fuel prices and to achieve the Corporation’s
interest rate objectives. The Corporation uses swaps, futures and/or forward contracts to mitigate the downside risk of
adverse price movements and hedge the exposure to variable cash flows. The use of these instruments also limits future 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 swaptions to secure near-term 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 with value fluctuations that 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. At December 31, 2002, the Corporation has not been required to provide collateral, nor has UPC
received collateral relating to its hedging activities.
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,
2002 and 2001, 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.
Sensitivity Analyses – The sensitivity analyses that follow illustrate the economic effect that hypothetical changes in interest
rates or fuel prices could have on the Corporation’s financial instruments. These hypothetical changes do not consider other
factors that could impact actual results.
Interest Rates – 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 as one of the tools to obtain the targeted mix. In addition, the Corporation also obtains
flexibility in managing interest costs and the interest rate mix within its debt portfolio by evaluating the issuance of and
managing outstanding callable fixed-rate debt securities.
At December 31, 2002 and 2001, the Corporation had variable-rate debt representing approximately 12% of its total debt.
If variable interest rates average 10% higher in 2003 than the Corporation’s December 31, 2002 variable rate, which was
approximately 3%, the Corporation’s interest expense would increase by less than $5 million after tax. If variable interest rates
had averaged 10% higher in 2002 than the Corporation’s December 31, 2001 variable rate, the Corporation’s interest expense
would have increased by less than $5 million after tax. These amounts were determined by considering the impact of the
hypothetical interest rates on the balances of the Corporation’s variable-rate debt at December 31, 2002 and 2001, respectively.
Swaps allow the Corporation to convert 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 Financial Accounting Standard (FAS) 133; therefore, no ineffectiveness has been