Union Pacific 2002 Annual Report Download - page 72

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2. Financial Instruments
Adoption of Standard - Effective January 1, 2001, the Corporation adopted Financial Accounting Standards Board Statement
(FASB) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133) and FASB No. 138, “Accounting for
Certain Derivative Instruments and Certain Hedging Activities” (FAS 138). FAS 133 and FAS 138 require that the changes in
fair value of all derivative financial instruments the Corporation uses for fuel or interest rate hedging purposes be recorded in
the Corporation’s Consolidated Statements of Financial Position. In addition, to the extent fuel hedges are ineffective due to
pricing differentials resulting from the geographic dispersion of the Corporation’s operations, income statement recognition of
the ineffective portion of the hedge position is required. Also, derivative instruments that do not qualify for hedge accounting
treatment per FAS 133 and FAS 138 require income statement recognition. The adoption of FAS 133 and FAS 138 resulted in
the recognition of a $2 million asset on January 1, 2001.
Strategy and Risk – 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.
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 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.
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
recorded within the Corporation’s Consolidated Financial Statements. In January 2002, the Corporation entered into an
interest rate swap on $250 million of debt with a maturity date of December 2006. In May 2002, the Corporation entered
into an interest rate swap on $150 million of debt with a maturity date of February 2023. This swap contained a call option
that matches the call option of the underlying hedged debt, as allowed by FAS 133. In January 2003, the swap’s counterparty
exercised their option to cancel the swap, effective February 1, 2003. Similarly, the Corporation has exercised its option to
redeem the underlying debt. As of December 31, 2002 and 2001, the Corporation had approximately $898 million and $598
million of interest rate swaps, respectively.