Union Pacific 2007 Annual Report Download - page 42

Download and view the complete annual report

Please find page 42 of the 2007 Union Pacific annual report below. You can navigate through the pages in the report by either clicking on the pages listed below, or by using the keyword search tool below to find specific information within the annual report.

Page out of 100

  • 1
  • 2
  • 3
  • 4
  • 5
  • 6
  • 7
  • 8
  • 9
  • 10
  • 11
  • 12
  • 13
  • 14
  • 15
  • 16
  • 17
  • 18
  • 19
  • 20
  • 21
  • 22
  • 23
  • 24
  • 25
  • 26
  • 27
  • 28
  • 29
  • 30
  • 31
  • 32
  • 33
  • 34
  • 35
  • 36
  • 37
  • 38
  • 39
  • 40
  • 41
  • 42
  • 43
  • 44
  • 45
  • 46
  • 47
  • 48
  • 49
  • 50
  • 51
  • 52
  • 53
  • 54
  • 55
  • 56
  • 57
  • 58
  • 59
  • 60
  • 61
  • 62
  • 63
  • 64
  • 65
  • 66
  • 67
  • 68
  • 69
  • 70
  • 71
  • 72
  • 73
  • 74
  • 75
  • 76
  • 77
  • 78
  • 79
  • 80
  • 81
  • 82
  • 83
  • 84
  • 85
  • 86
  • 87
  • 88
  • 89
  • 90
  • 91
  • 92
  • 93
  • 94
  • 95
  • 96
  • 97
  • 98
  • 99
  • 100

38
specified level of effectiveness between the hedging instrument and the item being hedged, both at inception
and throughout the hedged period. We formally document the nature and relationships between the hedging
instruments and hedged items at inception, as well as our risk-management objectives, strategies for
undertaking the various hedge transactions, and method of assessing hedge effectiveness. Changes in the fair
market value of derivative financial instruments that do not qualify for hedge accounting are charged to
earnings. We may use swaps, collars, futures, and/or forward contracts to mitigate the risk of adverse
movements in interest rates and fuel prices; however, the use of these derivative financial instruments may
limit future benefits from favorable price movements.
Market and Credit Risk – We address market risk related to derivative financial instruments by selecting
instruments with value fluctuations that highly correlate with the underlying hedged item. We manage credit
risk related to derivative financial instruments, which is minimal, by requiring high credit standards for
counterparties and periodic settlements. At December 31, 2007 and 2006, we were not required to provide
collateral, nor had we received collateral, relating to our hedging activities.
Determination of Fair Value – We determine the fair values of our derivative financial instrument positions
based upon current fair values as quoted by recognized dealers or the present value of expected future cash
flows.
Sensitivity Analyses – The sensitivity analyses that follow illustrate the economic effect that hypothetical
changes in interest rates could have on our results of operations and financial condition. These hypothetical
changes do not consider other factors that could impact actual results.
At December 31, 2007, we had variable-rate debt representing approximately 3% of our total debt. If variable
interest rates average one percentage point higher in 2008 than our December 31, 2007 variable rate, which
was approximately 7%, our interest expense would increase by approximately $3 million. This amount was
determined by considering the impact of the hypothetical interest rate on the balances of our variable-rate
debt at December 31, 2007.
Market risk for fixed-rate debt is estimated as the potential increase in fair value resulting from a hypothetical
one percentage point decrease in interest rates as of December 31, 2007, and amounts to an increase of
approximately $524 million to the fair value of our debt at December 31, 2007. We estimated the fair values of
our fixed-rate debt by considering the impact of the hypothetical interest rates on quoted market prices and
current borrowing rates.
Interest Rate Fair Value Hedges – We manage our overall exposure to fluctuations in interest rates by
adjusting the proportion of fixed and floating rate debt instruments within our debt portfolio over a given
period. We generally manage the mix of fixed and floating rate debt through the issuance of targeted amounts
of each as debt matures or as we require incremental borrowings. We employ derivatives, primarily swaps, as
one of the tools to obtain the targeted mix. In addition, we also obtain flexibility in managing interest costs
and the interest rate mix within our debt portfolio by evaluating the issuance of and managing outstanding
callable fixed-rate debt securities.
Swaps allow us 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 interest rates. We account for swaps as fair value hedges using
the short-cut method pursuant to Financial Accounting Standards Board (FASB) Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities; therefore, we do not record any ineffectiveness
within our Consolidated Financial Statements.
Interest Rate Cash Flow Hedges – We report changes in the fair value of cash flow hedges in accumulated
other comprehensive loss until the hedged item affects earnings. At December 31, 2007 and 2006, we had
reductions of $4 million and $5 million, respectively, recorded as an accumulated other comprehensive loss
that is being amortized on a straight-line basis through September 30, 2014. As of December 31, 2007 and
2006, we had no interest rate cash flow hedges outstanding.