Financial Instruments

6 Months Ended

Jun. 30, 2019

Derivative Instruments and Hedging Activities Disclosure [Abstract]

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 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. Both foreign exchange contracts and interest rate contracts are collectively referred to as derivative contracts ("derivative contracts"). The primary currencies to which PMI is exposed include the Australian dollar, Euro, Indonesian rupiah, Japanese yen, Mexican peso, Philippine peso, Russian ruble, Swiss franc and Turkish lira. At June 30, 2019, PMI had contracts with aggregate notional amounts of $28.1 billion of which $5.7 billion related to cash flow hedges, $11.3 billion related to hedges of net investments in foreign operations and $11.1 billion related to other derivatives that primarily offset currency exposures on intercompany financing.

The fair value of PMI’s derivative contracts included in the condensed consolidated balance sheets as of June 30, 2019 and December 31, 2018, were as follows:



	Derivative Assets					Derivative Liabilities
		Fair Value					Fair Value
(in millions)	Balance Sheet Classification	At June 30, 2019		At December 31, 2018		Balance Sheet Classification	At June 30, 2019		At December 31, 2018
Derivative contracts designated as hedging instruments	Other current assets	$	275	$	54	Other accrued liabilities	$	66	$	47
	Other assets	38		99		Other liabilities	491		525
Derivative contracts not designated as hedging instruments	Other current assets	64		67		Other accrued liabilities	79		46
	Other assets	—		—		Other liabilities	27		13
Total derivatives		$	377	$	220		$	663	$	631

For the six months and three months ended June 30, 2019 and 2018, 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 Six Months Ended June 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
	2019			2018				2019			2018
Derivatives in Cash Flow Hedging Relationship
Derivative contracts	$	(23	)	$	(12	)
							Net revenues	$	29		$	(7	)
							Cost of sales	—			—
							Marketing, administration and research costs	1			(3		)
							Interest expense, net	(2		)	(3		)
Derivatives in Net Investment Hedging Relationship
Derivative contracts	145			138
Total	$	122		$	126			$	28		$	(13	)



(pre-tax, in millions)	For the Three Months Ended June 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
	2019			2018			2019		2018
Derivatives in Cash Flow Hedging Relationship
Derivative contracts	$	(21	)	$	62
						Net revenues	$	19	$	2
						Cost of sales	—		—
						Marketing, administration and research costs	4		(11		)
						Interest expense, net	—		(1		)
Derivatives in Net Investment Hedging Relationship
Derivative contracts	(66		)	746
Total	$	(87	)	$	808		$	23	$	(10	)

Cash Flow Hedges

PMI has entered into derivative contracts to hedge the foreign currency exchange and interest rate risks related to certain forecasted transactions. 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. As of June 30, 2019, PMI has hedged forecasted transactions for periods not exceeding the next eighteen months with the exception of one derivative 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 derivative contracts as net investment hedges, primarily of its Euro net assets. For the six months ended June 30, 2019 and 2018, these hedges of net investments resulted in gains (losses), net of income taxes, of $173 million and $303 million, respectively, principally related to changes in the exchange rates between the Euro and U.S. dollar. For the three months ended June 30, 2019 and 2018, these hedges of net investments resulted in gains (losses), net of income taxes, of $(118) million and $1,060 million, respectively, principally related to changes in the exchange rates between the Euro and U.S. dollar. These gains (losses) were reported as a component of accumulated other comprehensive losses within currency translation adjustments, and were substantially offset by the losses and gains generated on the underlying assets. For the six months ended June 30, 2019 and 2018, the gains for amounts excluded from the effectiveness testing recognized in earnings were $117 million and $135 million, respectively. For the three months ended June 30, 2019 and 2018, the gains for amounts excluded from the effectiveness testing recognized in earnings were $61 million and $68 million, respectively. These gains were accounted for in interest expense, net, on the condensed consolidated statement of earnings. The premiums paid for, and settlements of, net investment hedges are included in investing cash flows on PMI’s condensed consolidated statements of cash flows.

Other Derivatives

PMI has entered into derivative 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 marketing, administration and research costs in PMI’s condensed consolidated statements of earnings. For the six months ended June 30, 2019 and 2018, the gains (losses) from contracts for which PMI did not apply hedge accounting were $(61) million and $334 million, respectively. For the three months ended June 30, 2019 and 2018, the gains (losses) from contracts for which PMI did not apply hedge accounting were $(54) million and $239 million, respectively. The gains (losses) from these contracts substantially offset the losses and gains generated by the underlying intercompany and third-party loans being hedged.

For the six months and three months ended June 30, 2019 and 2018, these items impacted the consolidated statement of earnings as follows:




(pre-tax, in millions)	For the Three Months Ended June 30,
Derivatives not Designated as Hedging Instruments	Statement of Earnings Classification of Gain/(Loss)	Amount of Gain/(Loss) Recognized in Earnings
		For the Six Months Ended June 30,				For the Three Months Ended June 30,
		2019		2018		2019		2018
Derivative contracts

	Interest expense, net	$	48	$	10	$	31	$	23
Total		$	48	$	10	$	31	$	23

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 Six Months Ended June 30,						For the Three Months Ended June 30,
	2019			2018			2019			2018
Gain/(loss) at beginning of period	$	35		$	42		$	30		$	(20	)
Derivative (gains)/losses transferred to earnings	(25		)	6			(21		)	4
Change in fair value	(20		)	(11		)	(19		)	53
Gain/(loss) as of June 30,	$	(10	)	$	37		$	(10	)	$	37

At June 30, 2019, PMI expects $10 million of derivative losses that are included in accumulated other comprehensive losses to be reclassified to the condensed consolidated statement of earnings within the next 12 months. These losses 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 limit 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.