DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

In the normal course of business, Eaton is exposed to certain risks related to fluctuations in interest rates, currency exchange rates and commodity prices. The Company uses various derivative and non-derivative financial instruments, primarily interest rate swaps, currency forward exchange contracts, currency swaps and, to a lesser extent, commodity contracts, to manage risks from these market fluctuations. The instruments used by Eaton are straightforward, non-leveraged instruments. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains control over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. Such instruments are not purchased and sold for trading purposes.

Derivative financial instruments are accounted for at fair value and recognized as assets or liabilities in the Condensed Consolidated Balance Sheets. Accounting for the gain or loss resulting from the change in the fair value of the derivative financial instrument depends on whether it has been designated, and is effective, as part of a hedging relationship and, if so, as to the nature of the hedging activity. Eaton formally documents all relationships between derivative financial instruments accounted for as designated hedges and the hedged item, as well as its risk-management objective and strategy for undertaking the hedge transaction. This process includes linking derivative financial instruments to a recognized asset or liability, specific firm commitment, forecasted transaction, or net investment in a foreign operation. These financial instruments can be designated as:

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Hedges of the change in the fair value of a recognized fixed-rate asset or liability, or the firm commitment to acquire such an asset or liability (a fair value hedge); for these hedges, the gain or loss from the derivative financial instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in income during the period of change in fair value.

•

Hedges of the variable cash flows of a recognized variable-rate asset or liability, or the forecasted acquisition of such an asset or liability (a cash flow hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive loss and reclassified to income in the same period when the gain or loss on the hedged item is included in income.

•

Hedges of the currency exposure related to a net investment in a foreign operation (a net investment hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive loss and reclassified to income in the same period when the gain or loss related to the net investment in the foreign operation is included in income.

The gain or loss from a derivative financial instrument designated as a hedge that is effective is classified in the same line of the Consolidated Statements of Income as the offsetting loss or gain on the hedged item. The change in fair value of a derivative financial instrument that is not effective as a hedge is immediately recognized in income. The cash flows resulting from these financial instruments are classified in operating activities on the Condensed Consolidated Statements of Cash Flows.

For derivatives that are not designated as a hedge, any gain or loss is immediately recognized in income. The majority of derivatives used in this manner relate to risks resulting from assets or liabilities denominated in a foreign currency and certain commodity contracts that arise in the normal course of business. Gains and losses associated with commodity hedge contracts are classified in Cost of products sold.

Eaton uses certain of its debt denominated in foreign currency to hedge portions of its net investments in foreign operations against foreign currency exposure (net investment hedges). Foreign currency denominated debt designated as non-derivative net investment hedging instruments on an after-tax basis was $90 at June 30, 2018 and $88 at December 31, 2017, and designated on a pre-tax basis was $634 at June 30, 2018 and $652 at December 31, 2017.

Derivative Financial Statement Impacts

The fair value of derivative financial instruments recognized in the Condensed Consolidated Balance Sheets follows:



	Notional amount		Other current assets		Other noncurrent assets		Other current liabilities		Other noncurrent liabilities		Type of hedge	Term
June 30, 2018
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	2,550	$	—	$	18	$	1	$	51	Fair value	9 months to 16 years
Currency exchange contracts	950		13		5		18		4		Cash flow	1 to 36 months
Total			$	13	$	23	$	19	$	55

Derivatives not designated as hedges
Currency exchange contracts	$	6,033	$	33			$	135				1 to 12 months
Commodity contracts	11		—				—					1 to 12 months
Total			$	33			$	135

December 31, 2017
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	2,965	$	1	$	41	$	—	$	17	Fair value	6 months to 17 years
Currency exchange contracts	924		7		7		22		2		Cash flow	1 to 36 months
Total			$	8	$	48	$	22	$	19

Derivatives not designated as hedges
Currency exchange contracts	$	3,719	$	39			$	19				1 to 12 months
Commodity contracts	13		1				—					1 to 12 months
Total			$	40			$	19

The currency exchange contracts shown in the table above as derivatives not designated as hedges are primarily contracts entered into to manage currency volatility or exposure on intercompany sales and loans. While Eaton does not elect hedge accounting treatment for these derivatives, Eaton targets managing 100% of the intercompany balance sheet exposure to minimize the effect of currency volatility related to the movement of goods and services in the normal course of its operations. This activity represents the great majority of these currency exchange contracts.

The impact of derivative instruments to the Consolidated Statement of Income and Comprehensive Income follow:



	Gain (loss) recognized in other comprehensive (loss) income						Location of gain (loss) reclassified from Accumulated other comprehensive loss	Gain (loss) reclassified from Accumulated other comprehensive loss
	Three months ended June 30							Three months ended June 30
	2018			2017				2018			2017
Derivatives designated as cash flow hedges
Forward starting floating-to-fixed interest rate swaps	$	—		$	(5	)	Interest expense - net	$	—		$	—
Currency exchange contracts	(15		)	2			Cost of products sold	(4		)	(1		)
Total	$	(15	)	$	(3	)		$	(4	)	$	(1	)


	Gain (loss) recognized in other comprehensive (loss) income						Location of gain (loss) reclassified from Accumulated other comprehensive loss	Gain (loss) reclassified from Accumulated other comprehensive loss
	Six months ended June 30							Six months ended June 30
	2018			2017				2018			2017
Derivatives designated as cash flow hedges
Forward starting floating-to-fixed interest rate swaps	$	—		$	(5	)	Interest expense - net	$	—		$	—
Currency exchange contracts	(2		)	1			Cost of products sold	(8		)	(5		)
Total	$	(2	)	$	(4	)		$	(8	)	$	(5	)

Amounts recognized in net income follow:



	Three months ended June 30						Six months ended June 30
	2018			2017			2018			2017
Derivatives designated as fair value hedges
Fixed-to-floating interest rate swaps	$	(16	)	$	8		$	(59	)	$	(3	)
Related long-term debt converted to floating interest rates by interest rate swaps	16			(8		)	59			3
	$	—		$	—		$	—		$	—

Gains and losses described above were recognized in Interest expense - net.