Union Pacific 2012 Annual Report Download - page 75

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75
13. Financial Instruments
Strategy and Risk – We may use derivative financial instruments in limited instances for other than
trading purposes to assist in managing our overall exposure to fluctuations in interest rates and fuel
prices. We are not a party to leveraged derivatives and, by policy, do not use derivative financial
instruments for speculative purposes. Derivative financial instruments qualifying for hedge accounting
must maintain a 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 interest rate and fuel
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, 2012 and 2011, 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. As of December 31, 2012 and 2011, we had no interest rate fair
value hedges outstanding.
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, 2012 and
2011, we had reductions of $1 million and $2 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, 2012 and 2011, 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 2012 2011 2010
Decrease in interest expense from interest rate hedging $ - $ - $ 2
Increase in pre-tax income $ - $ - $ 2
Fair Value of Financial Instruments – The fair value of our short- and long-term debt was estimated
using a market value price model, which utilizes applicable U.S. Treasury rates along with current market
quotes on comparable debt securities. All of the inputs used to determine the fair market value of the
Corporation’s long-term debt are Level 2 inputs and obtained from an independent source. At December
31, 2012, the fair value of total debt was $11.1 billion, approximately $2.1 billion more than the carrying
value. At December 31, 2011, the fair value of total debt was $10.5 billion, approximately $1.6 billion
more than the carrying value. The fair value of the Corporation’s debt is a measure of its current value