Financial Instruments

9 Months Ended

Sep. 30, 2011

5. Financial Instruments

Derivative Instruments and Hedging Activities

The Company manages the impact of foreign exchange rate movements and interest rate movements on its earnings, cash flows and fair values of assets and liabilities through operational means and through the use of various financial instruments, including derivative instruments.

A significant portion of the Company’s revenues and earnings in foreign affiliates is exposed to changes in foreign exchange rates. The objectives and accounting related to the Company’s foreign currency risk management program, as well as its interest rate risk management activities are discussed below.

Foreign Currency Risk Management

A significant portion of the Company’s revenues are denominated in foreign currencies. The Company has established revenue hedging and balance sheet risk management programs to protect against volatility of future foreign currency cash flows and changes in fair value caused by volatility in foreign exchange rates.

The objective of the revenue hedging program is to reduce the potential for longer-term unfavorable changes in foreign exchange to decrease the U.S. dollar value of future cash flows derived from foreign currency denominated sales, primarily the euro and Japanese yen. To achieve this objective, the Company will partially hedge forecasted foreign currency denominated third-party and intercompany distributor entity sales that are expected to occur over its planning cycle, typically no more than three years into the future. The Company will layer in hedges over time, increasing the portion of third-party and intercompany distributor entity sales hedged as it gets closer to the expected date of the forecasted foreign currency denominated sales, such that it is probable the hedged transaction will occur. The portion of sales hedged is based on assessments of cost-benefit profiles that consider natural offsetting exposures, revenue and exchange rate volatilities and correlations, and the cost of hedging instruments. The hedged anticipated sales are a specified component of a portfolio of similarly denominated foreign currency-based sales transactions, each of which responds to the hedged risk in the same manner. The Company manages its anticipated transaction exposure principally with purchased local currency put options, which provide the Company with a right, but not an obligation, to sell foreign currencies in the future at a predetermined price. If the U.S. dollar strengthens relative to the currency of the hedged anticipated sales, total changes in the options’ cash flows offset the decline in the expected future U.S. dollar cash flows of the hedged foreign currency sales. Conversely, if the U.S. dollar weakens, the options’ value reduces to zero, but the Company benefits from the increase in the value of the anticipated foreign currency cash flows.

In connection with the Company’s revenue hedging program, a purchased collar option strategy may be utilized. With a purchased collar option strategy, the Company writes a local currency call option and purchases a local currency put option. As compared to a purchased put option strategy alone, a purchased collar strategy reduces the upfront costs associated with purchasing puts through the collection of premium by writing call options. If the U.S. dollar weakens relative to the currency of the hedged anticipated sales, the purchased put option value of the collar strategy reduces to zero, but the Company benefit from the increase in the value of its anticipated foreign currency cash flows would be capped at the strike level of the written call. If the U.S. dollar strengthens relative to the currency of the hedged anticipated sales, the written call option value of the collar strategy reduces to zero and the changes in the purchased put cash flows of the collar strategy would offset the decline in the expected future U.S. dollar cash flows of the hedged foreign currency sales.

The Company may also utilize forward contracts in its revenue hedging program. If the U.S. dollar strengthens relative to the currency of the hedged anticipated sales, the increase in the fair value of the forward contracts offsets the decrease in the expected future U.S. dollar cash flows of the hedged foreign currency sales. Conversely, if the U.S. dollar weakens, the decrease in the fair value of the forward contracts offsets the increase in the value of the anticipated foreign currency cash flows.

The fair values of these derivative contracts are recorded as either assets (gain positions) or liabilities (loss positions) in the Consolidated Balance Sheet. Changes in the fair value of derivative contracts are recorded each period in either current earnings or Other comprehensive income (“OCI”), depending on whether the derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. For derivatives that are designated as cash flow hedges, the effective portion of the unrealized gains or losses on these contracts is recorded in Accumulated other comprehensive income (“AOCI”) and reclassified into Sales when the hedged anticipated revenue is recognized. The hedge relationship is highly effective and hedge ineffectiveness has been de minimis. For those derivatives which are not designated as cash flow hedges, unrealized gains or losses are recorded to Sales each period. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows. The Company does not enter into derivatives for trading or speculative purposes.

The primary objective of the balance sheet risk management program is to mitigate the exposure of foreign currency denominated net monetary assets of foreign subsidiaries where the U.S. dollar is the functional currency from the effects of volatility in foreign exchange that might occur prior to their conversion to U.S. dollars. In these instances, Merck principally utilizes forward exchange contracts, which enable the Company to buy and sell foreign currencies in the future at fixed exchange rates and economically offset the consequences of changes in foreign exchange from the monetary assets. Merck routinely enters into contracts to offset the effects of exchange on exposures denominated in developed country currencies, primarily the euro and Japanese yen. For exposures in developing country currencies, the Company will enter into forward contracts to partially offset the effects of exchange on exposures when it is deemed economical to do so based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The Company will also minimize the effect of exchange on monetary assets and liabilities by managing operating activities and net asset positions at the local level.

Foreign currency denominated monetary assets and liabilities of foreign subsidiaries where the U.S. dollar is the functional currency are remeasured at spot rates in effect on the balance sheet date with the effects of changes in spot rates reported in Other (income) expense, net. The forward contracts are not designated as hedges and are marked to market through Other (income) expense, net. Accordingly, fair value changes in the forward contracts help mitigate the changes in the value of the remeasured assets and liabilities attributable to changes in foreign currency exchange rates, except to the extent of the spot-forward differences. These differences are not significant due to the short-term nature of the contracts, which typically have average maturities at inception of less than one year.

When applicable, the Company uses forward contracts to hedge the changes in fair value of certain foreign currency denominated available-for-sale securities attributable to fluctuations in foreign currency exchange rates. These derivative contracts are designated as fair value hedges. Accordingly, changes in the fair value of the hedged securities due to fluctuations in spot rates are recorded in Other (income) expense, net, and are offset by the fair value changes in the forward contracts attributable to spot rate fluctuations. Changes in the contracts’ fair value due to spot-forward differences are excluded from the designated hedge relationship and recognized in Other (income) expense, net. These amounts, as well as hedge ineffectiveness, were not significant. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.

Foreign exchange risk is also managed through the use of foreign currency debt. The Company’s senior unsecured euro-denominated notes have been designated as, and are effective as, economic hedges of the net investment in a foreign operation. Accordingly, foreign currency transaction gains or losses on the euro-denominated debt instruments are included in foreign currency translation adjustment within OCI.

The Company also uses forward exchange contracts to hedge its net investment in foreign operations against adverse movements in exchange rates. The forward contracts are designated as hedges of the net investment in a foreign operation. The Company hedges a portion of the net investment in certain of its foreign operations and measures ineffectiveness based upon changes in spot foreign exchange rates. The effective portion of the unrealized gains or losses on these contracts is recorded in foreign currency translation adjustment within OCI, and remains in AOCI until either the sale or complete or substantially complete liquidation of the subsidiary. The cash flows from these contracts are reported as investing activities in the Consolidated Statement of Cash Flows.

Interest Rate Risk Management

In the third quarter of 2011, the Company terminated 11 interest rate swap contracts with a total notional amount of $1.6 billion. These swaps effectively converted $1.6 billion of its fixed-rate notes, with maturity dates ranging from June 2015 to January 2016, to floating rate instruments. As a result of the third quarter swap terminations, the Company received $113 million in cash, which included $7 million in accrued interest. The corresponding $106 million basis adjustment of the debt associated with the terminated swap contracts was deferred and is being amortized as a reduction of interest expense over the respective term of the notes. In the second quarter of 2011, the Company terminated nine interest rate swap contracts with a total notional amount of $3.5 billion. These swaps effectively converted $3.5 billion of its fixed-rate notes, with maturity dates ranging from March 2015 to June 2019, to floating rate instruments. As a result of the second quarter swap terminations, the Company received $175 million in cash, which included $36 million in accrued interest. The corresponding $139 million basis adjustment of the debt associated with the terminated swap contracts was deferred and is being amortized as a reduction of interest expense over the respective term of the notes. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.

At September 30, 2011, the Company was a party to two pay-floating, receive-fixed interest rate swap contracts that mature in the fourth quarter of 2011 with notional amounts of $125 million each that effectively convert the Company’s $250 million, 5.125% fixed-rate notes due 2011 to floating rate instruments. The interest rate swap contracts are designated hedges of the fair value changes in the notes attributable to changes in the benchmark London Interbank Offered Rate (“LIBOR”) swap rate. The fair value changes in the notes attributable to changes in the benchmark interest rate are recorded in interest expense and offset by the fair value changes in the swap contracts. The cash flows from these contracts are reported as operating activities in the Consolidated Statement of Cash Flows.

Presented in the table below is the fair value of derivatives segregated between those derivatives that are designated as hedging instruments and those that are not designated as hedging instruments:


		September 30, 2011						December 31, 2010
		Fair Value of Derivative				U.S. Dollar		Fair Value of Derivative				U.S. Dollar
($ in millions)	Balance Sheet Caption	Asset		Liability		Notional		Asset		Liability		Notional

Derivatives Designated as Hedging Instruments

Foreign exchange contracts (current)	Deferred income taxes and other current assets	$	147	$	—	$	3,115	$	167	$	—	$	2,344
Foreign exchange contracts (non-current)	Other assets		364		—		4,723		310		—		3,720
Foreign exchange contracts (current)	Accrued and other current liabilities		—		121		2,390		—		18		1,505
Foreign exchange contracts (non-current)	Deferred income taxes and noncurrent liabilities		—		2		59		—		6		503
Interest rate swaps (current)	Deferred income taxes and other current assets		6		—		250		—		—		—
Interest rate swaps (non-current)	Other assets		—		—		—		56		—		1,000
Interest rate swaps (non-current)	Deferred income taxes and noncurrent liabilities		—		—		—		—		7		850

		$	517	$	123	$	10,537	$	533	$	31	$	9,922


Derivatives Not Designated as Hedging Instruments

Foreign exchange contracts (current)	Deferred income taxes and other current assets	$	347	$	—	$	9,496	$	95	$	—	$	6,295

Foreign exchange contracts (current)	Accrued and other current liabilities		—		21		2,176		—		30		4,229

		$	347	$	21	$	11,672	$	95	$	30	$	10,524

		$	864	$	144	$	22,209	$	628	$	61	$	20,446

The table below provides information on the location and pretax gain or loss amounts for derivatives that are: (i) designated in a fair value hedging relationship, (ii) designated in a cash flow hedging relationship, (iii) designated in a foreign currency net investment hedging relationship and (iv) not designated in a hedging relationship:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
($ in millions)	2011			2010			2011			2010

Derivatives designated in fair value hedging relationships
Interest rate swap contracts
Amount of gain recognized in Other (income) expense, net on derivatives	$	(40	)	$	(29	)	$	(203	)	$	(64	)
Amount of loss recognized in Other (income) expense, net on hedged item		40			29			203			64

Derivatives designated in foreign currency cash flow hedging relationships
Foreign exchange contracts
Amount of loss (gain) reclassified from AOCI to Sales		30			(13	)		57			1
Amount of (gain) loss recognized in OCI on derivatives		(70	)		234			183			(50	)

Derivatives designated in foreign currency net investment hedging relationships
Foreign exchange contracts
Amount of gain recognized in Other (income) expense, net on derivatives ⁽¹⁾		(1	)		—			(9	)		—
Amount of loss recognized in OCI on derivatives		124			—			158			—

Derivatives not designated in a hedging relationship
Foreign exchange contracts
Amount of (gain) loss recognized in Other (income) expense, net on derivatives ⁽²⁾		(351	)		198			(31	)		13
Amount of loss (gain) recognized in Sales on hedged item		—			30			—			(83	)


⁽¹⁾		There was no ineffectiveness on the hedge. Represents the amount excluded from hedge effectiveness testing.

⁽²⁾		These derivative contracts mitigate changes in the value of remeasured foreign currency denominated monetary assets and liabilities attributable to changes in foreign currency exchange rates.

At September 30, 2011, the Company estimates $50 million of pretax net unrealized losses on derivatives maturing within the next 12 months that hedge foreign currency denominated sales over that same period will be reclassified from AOCI to Sales. The amount ultimately reclassified to Sales may differ as foreign exchange rates change. Realized gains and losses are ultimately determined by actual exchange rates at maturity.

Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Entities are required to use a fair value hierarchy which maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. There are three levels of inputs that may be used to measure fair value:

Level 1 - Quoted prices in active markets for identical assets or liabilities. The Company’s Level 1 assets include equity securities that are traded in an active exchange market.

Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. The Company’s Level 2 assets and liabilities primarily include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, corporate notes and bonds, U.S. and foreign government and agency securities, certain mortgage-backed and asset-backed securities, municipal securities, commercial paper and derivative contracts whose values are determined using pricing models with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3 - Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation. The Company’s Level 3 assets included certain mortgage-backed securities with limited market activity.

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis

Financial assets and liabilities measured at fair value on a recurring basis are summarized below:


	Fair Value Measurements Using								Fair Value Measurements Using
	Quoted Prices		Significant						Quoted Prices		Significant
	In Active		Other		Significant				In Active		Other		Significant
	Markets for		Observable		Unobservable				Markets for		Observable		Unobservable
	Identical Assets		Inputs		Inputs				Identical Assets		Inputs		Inputs
	(Level 1)		(Level 2)		(Level 3)		Total		(Level 1)		(Level 2)		(Level 3)		Total
($ in millions)	September 30, 2011								December 31, 2010

Assets
Investments
Corporate notes and bonds	$	—	$	1,554	$	—	$	1,554	$	—	$	1,133	$	—	$	1,133
Commercial paper		—		1,054		—		1,054		—		1,046		—		1,046
U.S. government and agency securities		—		605		—		605		—		500		—		500
Municipal securities		—		—		—		—		—		361		—		361
Asset-backed securities⁽¹⁾		—		173		—		173		—		171		—		171
Mortgage-backed securities⁽¹⁾		—		163		—		163		—		99		13		112
Foreign government bonds		—		51		—		51		—		10		—		10
Equity securities		94		49		—		143		117		23		—		140
Other debt securities		—		3		—		3		—		3		—		3

		94		3,652		—		3,746		117		3,346		13		3,476


Other assets
Securities held for employee compensation		184		—		—		184		181		—		—		181

Derivative assets ⁽²⁾
Purchased currency options		—		511		—		511		—		477		—		477
Forward exchange contracts		—		347		—		347		—		95		—		95
Interest rate swaps		—		6		—		6		—		56		—		56

		—		864		—		864		—		628		—		628

Total assets	$	278	$	4,516	$	—	$	4,794	$	298	$	3,974	$	13	$	4,285


Liabilities
Derivative liabilities ⁽²⁾
Written currency options	$	—	$	4	$	—	$	4	$	—	$	—	$	—	$	—
Forward exchange contracts		—		140		—		140		—		54		—		54
Interest rate swaps		—		—		—		—		—		7		—		7

Total liabilities	$	—	$	144	$	—	$	144	$	—	$	61	$	—	$	61


⁽¹⁾		Primarily all of the asset-backed securities are highly-rated (Standard & Poor’s rating of AAA and Moody’s Investors Service rating of Aaa), secured primarily by credit card, auto loan, and home equity receivables, with weighted-average lives of primarily 5 years or less. Mortgage-backed securities represent AAA-rated securities issued or unconditionally guaranteed as to payment of principal and interest by U.S. government agencies.

⁽²⁾		The fair value determination of derivatives includes an assessment of the credit risk of counterparties to the derivatives and the Company’s own credit risk, the effects of which were not significant.

There were no significant transfers between Level 1 and Level 2 during the third quarter or first nine months of 2011. As of September 30, 2011, Cash and cash equivalents of $14.3 billion included $13.3 billion of cash equivalents.

Level 3 Valuation Techniques:

Financial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial assets also include certain investment securities for which there is limited market activity such that the determination of fair value requires significant judgment or estimation. The Company’s Level 3 investment securities included certain mortgage-backed securities that were valued primarily using pricing models for which management understands the methodologies. These models incorporate transaction details such as contractual terms, maturity, timing and amount of future cash inflows, as well as assumptions about liquidity and credit valuation adjustments of marketplace participants.

The table below provides a summary of the changes in fair value of all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
($ in millions)	2011		2010			2011			2010

Beginning balance	$	—	$	17		$	13		$	72
Sales		—		(2	)		(13	)		(63	)
Settlements		—		—			—			(2	)
Total realized and unrealized gains (losses)
Included in:
Earnings ⁽¹⁾		—		—			—			18
Comprehensive income		—		—			—			(10	)

Ending balance	$	—	$	15		$	—		$	15

Losses recorded in earnings for Level 3 assets still held at September 30	$	—	$	—		$	—		$	—


⁽¹⁾		Amounts are recorded in Other (income) expense, net.

Financial Instruments not Measured at Fair Value

Some of the Company’s financial instruments are not measured at fair value on a recurring basis but are recorded at amounts that approximate fair value due to their liquid or short-term nature, such as cash and cash equivalents, receivables and payables.

The estimated fair value of loans payable and long-term debt (including current portion) at September 30, 2011 was $19.7 billion compared with a carrying value of $18.1 billion and at December 31, 2010 was $18.7 billion compared with a carrying value of $17.9 billion. Fair value was estimated using quoted dealer prices.

A summary of gross unrealized gains and losses on available-for-sale investments recorded in AOCI is as follows:


	September 30, 2011									December 31, 2010
	Fair		Amortized		Gross Unrealized					Fair		Amortized		Gross Unrealized
($ in millions)	Value		Cost		Gains		Losses			Value		Cost		Gains		Losses

Corporate notes and bonds	$	1,554	$	1,548	$	13	$	(7	)	$	1,133	$	1,124	$	12	$	(3	)
Commercial paper		1,054		1,054		—		—			1,046		1,046		—		—
U.S. government and agency securities		605		602		3		—			500		501		1		(2	)
Municipal securities		—		—		—		—			361		359		4		(2	)
Asset-backed securities		173		172		1		—			171		170		1		—
Mortgage-backed securities		163		162		2		(1	)		112		108		5		(1	)
Foreign government bonds		51		51		—		—			10		10		—		—
Other debt securities		3		1		2		—			3		1		2		—
Equity securities		327		313		14		—			321		295		34		(8	)

	$	3,930	$	3,903	$	35	$	(8	)	$	3,657	$	3,614	$	59	$	(16	)

Available-for-sale debt securities included in Short-term investments totaled $1.3 billion at September 30, 2011. Of the remaining debt securities, $2.0 billion mature within five years. At September 30, 2011, there were no debt securities pledged as collateral.

Concentrations of Credit Risk

On an ongoing basis, the Company monitors concentrations of credit risk associated with corporate issuers of securities and financial institutions with which it conducts business. Credit exposure limits are established to limit a concentration with any single issuer or institution. Cash and investments are placed in instruments that meet high credit quality standards, as specified in the Company’s investment policy guidelines. Approximately two-thirds of the Company’s cash and cash equivalents are invested in three highly-rated money market funds.

The majority of the Company’s accounts receivable arise from product sales in the United States and Europe and are primarily due from drug wholesalers and retailers, hospitals, government agencies, managed health care providers and pharmacy benefit managers. The Company monitors the financial performance and credit worthiness of its customers so that it can properly assess and respond to changes in their credit profile. The Company also continues to monitor economic conditions, including the volatility associated with international sovereign economies, and associated impacts on the financial markets and its business, taking into consideration the global economic downturn and the sovereign debt issues in certain European countries. The Company continues to monitor the credit and economic conditions within Greece, Spain, Italy and Portugal, among other members of the EU. These deteriorating economic conditions, as well as inherent variability of timing of cash receipts, have resulted in, and may continue to result in, an increase in the average length of time that it takes to collect accounts receivable outstanding. The Company does not expect to have write-offs or adjustments to accounts receivable which would have a material adverse impact on its financial position or results of operations. At September 30, 2011, the Company’s accounts receivable in Greece, Italy, Spain and Portugal totaled approximately $1.6 billion of which hospital and public sector receivables were approximately 75%. As of September 30, 2011, the Company’s total accounts receivable outstanding for more than one year were approximately $370 million, of which approximately 90% related to accounts receivable in Greece, Italy, Spain and Portugal, mostly comprised of hospital and public sector receivables.

As previously disclosed, the Company received zero coupon bonds from the Greek government in settlement of 2007-2009 receivables related to certain government sponsored institutions. During 2011, the Company sold a portion of these bonds. The Company has recorded impairment charges to reduce the remaining bonds to fair value and as of September 30, 2011, the balance was not material. During 2011, the Company has continued to receive payments on 2011 and 2010 Greek hospital and public sector receivables; these receivables totaled approximately $100 million as of September 30, 2011.

Derivative financial instruments are executed under International Swaps and Derivatives Association master agreements. The master agreements with several of the Company’s financial institution counterparties also include credit support annexes. These annexes contain provisions that require collateral to be exchanged depending on the value of the derivative assets and liabilities, the Company’s credit rating, and the credit rating of the counterparty. As of September 30, 2011 and December 31, 2010, the Company had received cash collateral of $378 million and $157 million, respectively, from various counterparties which is recorded in Accrued and other current liabilities. The Company had not advanced any cash collateral to counterparties as of September 30, 2011 or December 31, 2010.

- Definition

This item represents the complete disclosure regarding the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments, assets, and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the Company is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risk is are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information. This element can be used to disclose the entity's entire derivative instruments and hedging activities disclosure as a single block of text. Describes an entity's risk management strategies, derivatives in hedging activities and non-hedging derivative instruments, the assets, obligations, liabilities, revenues and expenses arising there from, and the amounts of and methodologies and assumptions used in determining the amounts of such items.

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