Union Pacific 2009 Annual Report Download - page 84

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84
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, 2009 and 2008, 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.
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; therefore, we do not record any ineffectiveness within our
Consolidated Financial Statements.
The following is a summary of our interest rate derivatives qualifying as fair value hedges:
Millions of Dollars, Except Percentages 2009 2008
Amount of debt hedged $ 250 $ 250
Percentage of total debt portfolio 3% 3
%
Gross fair value asset position $ 15 $ 19
We recognized the fair value as a Level 2 valuation. A Level 2 valuation is defined as observable market-
based inputs or unobservable inputs that are corroborated by market data.
Interest Rate Cash Flow Hedges – We report changes in the fair value of cash flow hedges in
accumulated other comprehensive income/loss until the hedged item affects earnings. At December 31,
2009 and 2008, we had reductions of $3 million and $4 million, respectively, recorded as an accumulated
other comprehensive income/loss that is being amortized on a straight-line basis through September 30,
2014. As of December 31, 2009 and 2008, we had no interest rate cash flow hedges outstanding.
Earnings Impact – Our use of derivative financial instruments had the following impact on pre-tax
income for the years ended December 31:
Millions of Dollars 2009 2008 2007
(Increase)/decrease in interest expense from interest rate hedging $ 8 $ 1 $ (8)
(Increase)/decrease in fuel expense from fuel derivatives - 1 (1)
Increase/(decrease) in pre-tax income $ 8 $ 2 $ (9)
Fair Value of Debt Instruments – The fair value of our short- and long-term debt was estimated using
quoted market prices, where available, or current borrowing rates. At December 31, 2009, the fair value