Financial Instruments:

Overview

PMI operates in markets outside of the United States of America, with manufacturing and sales facilities in various locations around the world. PMI utilizes certain financial instruments to manage foreign currency and interest rate exposure. Derivative financial instruments are used by PMI principally to reduce exposures to market risks resulting from fluctuations in foreign currency exchange and interest rates by creating offsetting exposures. PMI is not a party to leveraged derivatives and, by policy, does not use derivative financial instruments for speculative purposes. 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. PMI formally documents the nature and relationships between the hedging instruments and hedged items, as well as its risk-management objectives, strategies for undertaking the various hedge transactions and method of assessing hedge effectiveness. Additionally, for hedges of forecasted transactions, the significant characteristics and expected terms of the forecasted transaction must be specifically identified, and it must be probable that each forecasted transaction will occur. If it were deemed probable that the forecasted transaction would not occur, the gain or loss would be recognized in earnings. PMI reports its net transaction gains or losses in marketing, administration and research costs on the condensed consolidated statements of earnings.

PMI uses deliverable and non-deliverable forward foreign exchange contracts, foreign currency swaps and foreign currency options, collectively referred to as foreign exchange contracts ("foreign exchange contracts"), and interest rate contracts to mitigate its exposure to changes in exchange and interest rates from third-party and intercompany actual and forecasted transactions. The primary currencies to which PMI is exposed include the Australian dollar, Canadian dollar, Euro, Indonesian rupiah, Japanese yen, Mexican peso, Russian ruble, Swiss franc and Turkish lira. At September 30, 2017, PMI had contracts with aggregate notional amounts of $32.7 billion of which $5.0 billion related to cash flow hedges, $12.8 billion related to hedges of net investments in foreign operations and $14.9 billion related to other derivatives that primarily offset currency exposures on intercompany financing.

The fair value of PMI’s foreign exchange contracts included in the condensed consolidated balance sheets as of September 30, 2017 and December 31, 2016, were as follows:



	Asset Derivatives					Liability Derivatives
		Fair Value					Fair Value
(in millions)	Balance Sheet Classification	At September 30, 2017		At December 31, 2016		Balance Sheet Classification	At September 30, 2017		At December 31, 2016
Foreign exchange contracts designated as hedging instruments	Other current assets	$	100	$	207	Other accrued liabilities	$	279	$	66
	Other assets	79		436		Other liabilities	718		36
Foreign exchange contracts not designated as hedging instruments	Other current assets	76		161		Other accrued liabilities	64		61
	Other assets	—		9		Other liabilities	6		—
Total derivatives		$	255	$	813		$	1,067	$	163

For the nine months and three months ended September 30, 2017 and 2016, PMI's cash flow and net investment hedging instruments impacted the condensed consolidated statements of earnings and comprehensive earnings as follows:



(pre-tax, in millions)	For the Nine Months Ended September 30,
	Amount of Gain/(Loss) Recognized in Other Comprehensive Earnings/(Losses) on Derivatives						Statement of Earnings Classification of Gain/(Loss) Reclassified from Other Comprehensive Earnings/(Losses) into Earnings	Amount of Gain/(Loss) Reclassified from Other Comprehensive Earnings/(Losses) into Earnings
	2017			2016				2017			2016
Derivatives in Cash Flow Hedging Relationship
Foreign exchange contracts	$	(55	)	$	(215	)
							Net revenues	$	28		$	(29	)
							Cost of sales	1			41
							Marketing, administration and research costs	(5		)	2
							Interest expense, net	(27		)	(39		)
Derivatives in Net Investment Hedging Relationship
Foreign exchange contracts	(1,432		)	(209		)
Total	$	(1,487	)	$	(424	)		$	(3	)	$	(25	)



(pre-tax, in millions)	For the Three Months Ended September 30,
	Amount of Gain/(Loss) Recognized in Other Comprehensive Earnings/(Losses) on Derivatives						Statement of Earnings Classification of Gain/(Loss) Reclassified from Other Comprehensive Earnings/(Losses) into Earnings	Amount of Gain/(Loss) Reclassified from Other Comprehensive Earnings/(Losses) into Earnings
	2017			2016				2017			2016
Derivatives in Cash Flow Hedging Relationship
Foreign exchange contracts	$	6		$	(12	)
							Net revenues	$	13		$	(28	)
							Cost of sales	1			16
							Marketing, administration and research costs	(5		)	3
							Interest expense, net	(15		)	(10		)
Derivatives in Net Investment Hedging Relationship
Foreign exchange contracts	(492		)	(150		)
Total	$	(486	)	$	(162	)		$	(6	)	$	(19	)

Cash Flow Hedges

PMI has entered into foreign exchange contracts to hedge the foreign currency exchange and interest rate risks related to certain forecasted transactions. The effective portion of gains and losses associated with qualifying cash flow hedge contracts is deferred as a component of accumulated other comprehensive losses until the underlying hedged transactions are reported in PMI’s condensed consolidated statements of earnings. During the nine months and three months ended September 30, 2017 and 2016, ineffectiveness related to cash flow hedges was not material. As of September 30, 2017, PMI has hedged forecasted transactions for periods not exceeding the next fifteen months with the exception of one foreign exchange contract that expires in May 2024. The impact of these hedges is primarily included in operating cash flows on PMI’s condensed consolidated statements of cash flows.

Hedges of Net Investments in Foreign Operations

PMI designates certain foreign currency denominated debt and foreign exchange contracts as net investment hedges of its foreign operations. For the nine months ended September 30, 2017 and 2016, these hedges of net investments resulted in losses, net of income taxes, of $1,504 million and $232 million, respectively. For the three months ended September 30, 2017 and 2016, these hedges of net investments resulted in losses, net of income taxes, of $478 million and $153 million, respectively. These losses were reported as a component of accumulated other comprehensive losses within currency translation adjustments. For the nine months and three months ended September 30, 2017 and 2016, ineffectiveness related to net investment hedges was not material. The premiums paid for, and settlements of, net investment hedges are included in net investment hedges and other investing cash flows on PMI’s condensed consolidated statements of cash flows.

Other Derivatives

PMI has entered into foreign exchange contracts to hedge the foreign currency exchange and interest rate risks related to intercompany loans between certain subsidiaries, and third-party loans. While effective as economic hedges, no hedge accounting is applied for these contracts; therefore, the unrealized gains (losses) relating to these contracts are reported in PMI’s condensed consolidated statements of earnings. For the nine months ended September 30, 2017 and 2016, the gains from contracts for which PMI did not apply hedge accounting were $344 million and $101 million, respectively. For the three months ended September 30, 2017 and 2016, the gains from contracts for which PMI did not apply hedge accounting were $195 million and $32 million, respectively. The gains from these contracts substantially offset the losses generated by the underlying intercompany and third-party loans being hedged.

For the nine months and three months ended September 30, 2017 and 2016, the net impact of these contracts on the condensed consolidated statements of earnings was not material.

Qualifying Hedging Activities Reported in Accumulated Other Comprehensive Losses

Derivative gains or losses reported in accumulated other comprehensive losses are a result of qualifying hedging activity. Transfers of these gains or losses to earnings are offset by the corresponding gains or losses on the underlying hedged item. Hedging activity affected accumulated other comprehensive losses, net of income taxes, as follows:



(in millions)	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2017			2016			2017		2016
Gain/(loss) at beginning of period	$	97		$	59		$	42	$	(111	)
Derivative (gains)/losses transferred to earnings	4			19			6		16
Change in fair value	(48		)	(184		)	5		(11		)
Gain/(loss) at of September 30,	$	53		$	(106	)	$	53	$	(106	)

At September 30, 2017, PMI expects $42 million of derivative gains that are included in accumulated other comprehensive losses to be reclassified to the condensed consolidated statement of earnings within the next 12 months. These gains are expected to be substantially offset by the statement of earnings impact of the respective hedged transactions.

Contingent Features

PMI’s derivative instruments do not contain contingent features.

Credit Exposure and Credit Risk

PMI is exposed to credit loss in the event of non-performance by counterparties. While PMI does not anticipate non-performance, its risk is limited to the fair value of the financial instruments less any cash collateral received or pledged. PMI actively monitors its exposure to credit risk through the use of credit approvals and credit limits, and by selecting and continuously monitoring a diverse group of major international banks and financial institutions as counterparties.

Fair Value

See Note 11. Fair Value Measurements and Note 13. Balance Sheet Offsetting for additional discussion of derivative financial instruments.