Financial Instruments

We enter into derivative instruments for risk management purposes only, including derivatives designated as hedging instruments under the Derivatives and Hedging Topic of the FASB ASC and those utilized as economic hedges. We operate internationally and, in the normal course of business, are exposed to fluctuations in interest rates, foreign exchange rates and commodity prices. These fluctuations can increase the costs of financing, investing and operating the business. We have used derivative instruments, including swaps, forward contracts and options to manage certain foreign currency, interest rate and commodity price exposures.

By their nature, all financial instruments involve market and credit risks. We enter into derivative and other financial instruments with major investment grade financial institutions and have policies to monitor the credit risk of those counterparties. We limit counterparty exposure and concentration of risk by diversifying counterparties. While there can be no assurance, we do not anticipate any material non-performance by any of these counterparties.

Foreign Currency Forward Contracts. We manage our foreign currency transaction risks to acceptable limits through the use of derivatives that hedge forecasted cash flows associated with foreign currency transaction exposures, which are accounted for as cash flow hedges, as we deem appropriate. To the extent these derivatives are effective in offsetting the variability of the hedged cash flows, and otherwise meet the hedge accounting criteria of the Derivatives and Hedging Topic of the FASB ASC, the changes in the derivatives’ fair values are not included in current earnings but are included in “Accumulated other comprehensive loss.” These changes in fair value will subsequently be reclassified into earnings as a component of product sales or expenses, as applicable, when the forecasted transaction occurs. To the extent that a previously designated hedging transaction is no longer an effective hedge, any ineffectiveness measured in the hedging relationship is recorded currently in earnings in the period in which it occurs.

To the extent the hedge accounting criteria are not met, the foreign currency forward contracts are utilized as economic hedges and changes in the fair value of these contracts are recorded currently in earnings in the period in which they occur. These include hedges that are used to reduce exchange rate risks arising from the change in fair value of certain foreign currency denominated assets and liabilities (e.g. payables, receivables) and other economic hedges where the hedge accounting criteria were not met.

The four quarter rolling average of the notional amount of foreign exchange contracts hedging foreign currency transactions was $12.5 billion and $11.8 billion at June 30, 2013 and December 31, 2012, respectively.

We enter into transactions that are subject to arrangements designed to provide for netting of offsetting obligations in the event of the insolvency or default of a counterparty. However, we have not elected to offset multiple contracts with a single counterparty and, as a result, the fair value of the derivative instruments in a loss position is not offset against the fair value of derivative instruments in a gain position.

The following table summarizes the fair value of derivative instruments as of June 30, 2013 and December 31, 2012 which consist solely of foreign exchange contracts:



	June 30, 2013				December 31, 2012
(Dollars in millions)	Derivatives designated as hedging instruments		Derivatives not designated as hedging instruments		Derivatives designated as hedging instruments		Derivatives not designated as hedging instruments
Balance Sheet Asset Locations:
Other assets, current	$	8	$	82	$	48	$	47
Other assets	3		5		30		3
	11		87		78		50
Total Asset Derivative Contracts			$	98			$	128
Balance Sheet Liability Locations:
Accrued liabilities	$	53	$	111	$	10	$	136
Other long-term liabilities	40		1		1		2
	93		112		11		138
Total Liability Derivative Contracts			$	205			$	149

The impact from foreign exchange derivative instruments that qualified as cash flow hedges was as follows:



	Quarter Ended June 30,						Six Months Ended June 30,
(Dollars in millions)	2013			2012			2013			2012
Loss recorded in Accumulated other comprehensive loss	$	(64	)	$	(155	)	$	(161	)	$	(63	)
Loss reclassified from Accumulated other comprehensive loss into Product sales (effective portion)	$	(15	)	$	(8	)	$	(23	)	$	(19	)

Assuming current market conditions continue, a $21 million pre-tax loss is expected to be reclassified from Accumulated other comprehensive loss into Product sales to reflect the fixed prices obtained from foreign exchange hedging within the next 12 months. At June 30, 2013, all derivative contracts accounted for as cash flow hedges will mature by July 2015.

The effect on the Condensed Consolidated Statement of Comprehensive Income from foreign exchange contracts not designated as hedging instruments was as follows:



	Quarter Ended June 30,						Six Months Ended June 30,
(Dollars in millions)	2013			2012			2013		2012
(Loss) gain recognized in Other income, net	$	(9	)	$	(78	)	$	23	$	(40	)

Valuation Hierarchy. The following table provides the valuation hierarchy classification of assets and liabilities that are carried at fair value and measured on a recurring and nonrecurring basis in our Condensed Consolidated Balance Sheet as of June 30, 2013 and December 31, 2012:



(Dollars in millions)	Total Carrying Value at June 30, 2013			Quoted price in active markets (Level 1)		Significant other observable inputs (Level 2)			Unobservable inputs (Level 3)
Recurring fair value measurements:
Available-for-sale securities	$	827		$	827	$	—		$	—
Derivative assets	98			—		98			—
Derivative liabilities	(205		)	—		(205		)	—
Nonrecurring fair value measurements:
Business dispositions	13			—		13			—

During the six months ended June 30, 2013, we recorded an approximately $38 million net gain from UTC Climate, Controls & Security's ongoing portfolio transformation, primarily due to a gain on the sale of a business in Hong Kong. In addition, we recorded an approximately $193 million gain from the sale of the Pratt & Whitney Power Systems business (see Note 1).



(Dollars in millions)	Total Carrying Value at December 31, 2012			Quoted price in active markets (Level 1)		Significant other observable inputs (Level 2)			Unobservable inputs (Level 3)
Recurring fair value measurements:
Available-for-sale securities	$	781		$	781	$	—		$	—
Derivative assets	128			—		128			—
Derivative liabilities	(149		)	—		(149		)	—
Nonrecurring fair value measurements:
Equity method investment	432			—		432			—
Business dispositions	84			—		84			—

During the six months ended June 30, 2012, we recorded net gains on nonrecurring fair value measurements of approximately $222 million within Other income, net from UTC Climate, Controls & Security's ongoing portfolio transformation efforts. These net gains include approximately $357 million from the sales of controlling interests in manufacturing and distribution joint ventures in Asia and Canada, of which approximately $272 million were non-cash. These gains were partially offset by $103 million of other-than-temporary impairment charges related to business dispositions and a $32 million loss on the disposition of the U.S. fire and security branch operations.

Valuation Techniques. Our available-for-sale securities include equity investments that are traded in active markets, either domestically or internationally. They are measured at fair value using closing stock prices from active markets and are classified within Level 1 of the valuation hierarchy. Our derivative assets and liabilities are managed on the basis of net exposure to market and credit risks of each of the counterparties. The fair value for these derivative assets and liabilities is measured at the price that would be received on a net asset position for a particular risk or to transfer a net liability position for a particular risk in an orderly transaction between market participants at the measurement date. Our derivative assets and liabilities include foreign exchange contracts and commodity derivatives that are measured at fair value using internal models based on observable market inputs such as forward rates, interest rates, our own credit risk and our counterparties’ credit risks. Based on these inputs, the derivative assets and liabilities are classified within Level 2 of the valuation hierarchy. Based on our continued ability to trade securities and enter into forward contracts, we consider the markets for our fair value instruments to be active. As of June 30, 2013, there were no significant transfers in and out of Level 1 and Level 2.

As of June 30, 2013, there has not been any significant impact to the fair value of our derivative liabilities due to our own credit risk. Similarly, there has not been any significant adverse impact to our derivative assets based on our evaluation of our counterparties’ credit risks.

The following table provides carrying amounts and fair values of financial instruments that are not carried at fair value in our Condensed Consolidated Balance Sheet at June 30, 2013 and December 31, 2012:



	June 30, 2013						December 31, 2012
(Dollars in millions)	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Long-term receivables	$	646		$	586		$	499		$	464
Customer financing notes receivable	408			354			375			371
Short-term borrowings	(196		)	(196		)	(503		)	(503		)
Long-term debt (excluding capitalized leases)	(21,412		)	(21,890		)	(22,665		)	(25,606		)
Long-term liabilities	(279		)	(250		)	(182		)	(167		)

The following table provides the valuation hierarchy classification of assets and liabilities that are not carried at fair value in our Condensed Consolidated Balance Sheet as of June 30, 2013:



(Dollars in millions)	Total Fair Value at June 30, 2013			Quoted price in active markets (Level 1)		Significant other observable inputs (Level 2)			Unobservable inputs (Level 3)
Long-term receivables	$	586		$	—	$	586		$	—
Customer financing notes receivable	354			—		354			—
Short-term borrowings	(196		)	—		(50		)	(146		)
Long-term debt (excluding capitalized leases)	(21,890		)	—		(21,787		)	(103		)
Long-term liabilities	(250		)	—		(250		)	—

Valuation Techniques. Our long-term receivables and customer financing notes receivable include our commercial and aerospace long-term trade, government and other receivables, leases, and notes receivable. Our long-term receivables and customer financing notes receivable are measured and presented in the table above at fair value using an income approach based on the present value of the contractual, promised or most likely cash flows discounted at observed or estimated market rate for comparable assets or liabilities that are traded in the market. Based on these inputs, long-term receivables and customer financing notes receivable are presented in the table above within Level 2 of the valuation hierarchy. Our short-term borrowings include commercial paper and other international credit facility agreements. Our long-term debt includes domestic and international notes. Commercial paper and domestic long-term notes are measured and presented in the table above at fair values based on comparable transactions and current market interest rates quoted in active markets for similar assets, and are classified within Level 2 of the valuation hierarchy. Foreign short-term borrowings and foreign long-term notes are measured and presented in the table above at fair value based on comparable transactions and rates calculated from the respective countries’ yield curves. Based on these inputs, foreign borrowings and foreign long-term notes are classified within Level 3 of the valuation hierarchy. The fair values of Accounts receivable and Accounts payable approximate the carrying amounts due to the short-term maturities of these instruments.

We had commercial aerospace financing and other contractual commitments totaling approximately $12.1 billion at June 30, 2013, including approximately $6.5 billion of IAE commitments, related to commercial aircraft and certain contractual rights to provide product on new aircraft platforms. We had commercial aerospace financing and other contractual commitments of approximately $10.9 billion at December 31, 2012, which included approximately $5.8 billion of IAE commitments. Risks associated with changes in interest rates on these commitments are mitigated by the fact that interest rates are variable during the commitment term, and are set at the date of funding based on current market conditions, the fair value of the underlying collateral and the credit worthiness of the customers. As a result, the fair value of these financings is expected to equal the amounts funded. The fair value of the commitment itself is not readily determinable.