Derivative Financial Instruments

3 Months Ended

Mar. 31, 2020

Derivative Financial Instruments

Derivative Financial Instruments

12. Derivative Financial Instruments:

The company operates in multiple currencies and is a lender and issuer in the capital markets and a borrower from IBM. In the normal course of business, the company may be exposed to the impact of interest rate changes and foreign currency fluctuations. The company limits its exposure to core market risks by following established risk management policies and procedures, and through the use of match-funding with IBM and third parties. Although the company seeks to substantially match-fund the terms, currency and interest rate variability of its debt against its underlying financial assets, risks may arise between assets and the related liabilities used for funding. The company may also choose to mitigate any remaining exposure relating to interest rate changes and foreign currency fluctuations through the use of interest rate or foreign exchange derivatives.

Derivative assets and liabilities are recorded in other assets and other liabilities in the Consolidated Balance Sheet and are presented on a gross basis. The notional amounts of the derivative instruments do not necessarily represent amounts exchanged by the company with IBM and third parties, and are not necessarily a direct measure of the financial exposure. The company also enters into master netting agreements with certain counterparties that allow for netting of exposures in the event of default or breach. However, in the Consolidated Balance Sheet, the company does not offset derivative assets against liabilities in master netting arrangements. If derivatives exposures covered by a qualifying master netting agreement with IBM had been netted in the Consolidated Balance Sheet at March 31, 2020 and December 31, 2019, the total derivative asset and liability positions would each have been reduced by $14 million and $18 million, respectively.

Interest Rate Risk

Fixed and Variable Rate Borrowings

The company issues debt in the capital markets to fund its operations. Access to cost-effective financing can result in interest rate mismatches with the underlying assets. To manage these mismatches and to reduce overall interest cost, the company may enter into interest-rate swaps with IBM to convert specific fixed-rate debt issuances into variable-rate debt (i.e., fair value hedges) and to convert variable-rate debt issuances into fixed-rate debt (i.e., cash flow hedges). At March 31, 2020 and December 31, 2019, the total notional amount of the company's interest rate swap contracts with IBM was $2,550 million at both periods. The weighted average remaining maturity of these instruments at March 31, 2020 and December 31, 2019, was approximately 1.7 years and 2.0 years, respectively. These interest rate contracts were accounted for as fair value hedges. The company did not have any cash flow hedges relating to this program outstanding at March 31, 2020 and December 31, 2019.

Foreign Exchange Risk

Long-Term Investments in Foreign Subsidiaries (Net Investment)

The company enters into foreign exchange derivatives with IBM as a hedge of net investment of its foreign subsidiaries to reduce the volatility in member's interest caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. At March 31, 2020 and December 31, 2019, the total notional amount of derivative contracts with IBM designated as net investment hedges was $1,027 million and

$1,229 million, respectively. The weighted average remaining maturity of these instruments was 0.2 years at both periods.

Foreign Currency Asset/Liability Management

The company enters into foreign exchange derivative contracts to manage foreign currency exposures associated with the company’s funding from IBM and third parties. These derivatives are not designated as hedges for accounting purposes. However, these derivatives represent economic hedges which provide an economic offset to the underlying foreign currency exposure. The terms of these derivative contracts are generally less than one year. The gains and losses recognized on economic hedges are recorded in other (income) and expense in the Consolidated Income Statement, and the associated cash flows are included in other investing activities-net, in the Consolidated Statement of Cash Flows.

There were no foreign exchange derivative contracts with third parties outstanding at March 31, 2020 and December 31, 2019.

The following tables provide a quantitative summary of the derivative instrument-related risk management activity at March 31, 2020 and December 31, 2019, as well as for the three months ended March 31, 2020 and 2019, respectively.

Cumulative Basis Adjustments for Fair Value Hedges

At March 31, 2020 and December 31, 2019, the following amounts were recorded in the Consolidated Balance Sheet related to cumulative basis adjustments for fair value hedges:

(Dollars in millions)
Line Item in the Consolidated Balance Sheet	At March 31,		At December 31,
in which the Hedged Item is Included:	2020		2019
Debt:
Carrying amount of the hedged item	$	(2,623)	$	(2,574)
Cumulative hedging adjustments included in the carrying amount - assets/(liabilities)		(76)		(28)

The Effect of Derivative Instruments in the Consolidated Income Statement

The total amounts of income and expense line items presented in the Consolidated Income Statement in which the effects of fair value hedges, net investment hedges and derivatives not designated as hedging instruments are recorded and the total effect of hedge activity on these income and expense line items, are as follows:

					Gains/(Losses) of
(Dollars in millions)	Total				Total Hedge Activity
For the three months ended March 31:	2020		2019		2020		2019
Financing cost	$	105	$	160	$	9	$	4
Other (income) and expense		(21)		(18)		—		—

	Gain/(Loss) Recognized in Consolidated Income Statement
	Consolidated	Recognized on				Attributable to Risk
(Dollars in millions)	Income Statement	Derivatives				Being Hedged (2)
For the three months ended March 31:	Line Item	2020		2019		2020		2019
Derivative instruments in fair value hedges (1):
Interest rate contracts with IBM	Financing cost	$	51	$	20	$	(48)	$	(25)
Total		$	51	$	20	$	(48)	$	(25)

	Gain/(Loss) Recognized in Consolidated Income Statement and Other Comprehensive Income
					Consolidated
					Income	Reclassified				Amounts Excluded from
(Dollars in millions)	Recognized in OCI				Statement	from AOCI				Effectiveness Testing (3)
For the three months ended March 31:	2020		2019		Line Item	2020		2019		2020		2019
Derivative instruments in net investment hedges:
Foreign exchange contracts with IBM	$	67	$	(10)	Financing cost	$	—	$	—	$	6	$	10
Total	$	67	$	(10)		$	—	$	—	$	6	$	10

(1) The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.

(2) The amount includes basis adjustments to the carrying value of the hedged item recorded during the period.

(3) The company's policy is to recognize all fair value changes in amounts excluded from effectiveness testing in net income each period.

For the three months ending March 31, 2020 and 2019, there were no material gains or losses excluded from the assessment of hedge effectiveness (for fair value hedges); nor are there any anticipated in the normal course of business.