Derivative Financial Instruments and Hedging Activities

6 Months Ended

Jun. 30, 2011

Derivative Instruments and Hedging Activities Disclosure [Abstract]

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

In the normal course of business, our operations are exposed to global market risks, including the effect of changes in interest rates and foreign currency exchange rates. To manage these risks, we enter into various derivative contracts.

• Interest rate contracts including swaps, caps and floors are used to manage the effects of interest rate fluctuations;

• Foreign exchange forward contracts are used to manage foreign exchange exposure; and

• Cross-currency interest rate swap contracts are used to manage foreign currency and interest rate exposures on foreign denominated debt.

Our derivatives are over-the-counter customized derivative transactions and are not exchange traded. We review our hedging program, derivative positions, and overall risk management on a regular basis.

We have elected to apply hedge accounting to certain derivatives. Derivatives that receive designated hedge accounting treatment are documented and the relationships are evaluated for effectiveness using regression analysis at the time they are designated, and throughout the hedge period. Cash flows and profit impact associated with designated hedges are reported in the same category as the underlying hedged item. Some derivatives do not qualify for hedge accounting; for others, we elect not to apply hedge accounting. Regardless of hedge accounting treatment, we only enter into transactions we believe will be highly effective at offsetting the underlying economic risk.

NOTE 11. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES (Continued)

Fair Value Hedges. We use certain derivatives to reduce the risk of changes in the fair value of liabilities. We have designated certain receive-fixed, pay-float interest rate swaps as fair value hedges of fixed-rate debt. The risk being hedged is the risk of changes in the fair value of the hedged debt attributable to changes in the benchmark interest rate. If the hedge relationship is deemed to be highly effective, we record the changes in the fair value of the hedged debt related to the risk being hedged in Debt with the offset in Other income, net. The change in fair value of the related derivative (excluding accrued interest) also is recorded in Other income, net. Hedge ineffectiveness, recorded directly in earnings, is the difference between the change in fair value of the derivative and the change in the fair value of the hedged debt that is attributable to the changes in the benchmark interest rate. The cash flows associated with fair value hedges are reported in Cash flows from operating activities in our consolidated statement of cash flows.

When a derivative is de-designated from a fair value hedge relationship, or when the derivative in a fair value hedge relationship is terminated before maturity, the fair value adjustment to the hedged debt continues to be reported as part of the carrying value of the debt and is amortized over its remaining life.

Derivatives Not Designated as Hedging Instruments. We report changes in the fair value of derivatives not designated as hedging instruments in Other income, net. The earnings impact primarily relates to changes in fair value of interest rate derivatives, which are included in evaluating our overall risk management objective, and foreign currency derivatives, which are substantially offset by the revaluation of foreign denominated debt. The cash flows associated with derivatives not designated as hedging instruments are reported in Cash flows from investing activities in our consolidated statement of cash flows.

Income Effect of Derivative Financial Instruments

The following table summarizes by hedge designation the pre-tax gain/(loss) for the periods ended June 30 (in millions):

	Second Quarter						First Half
	2011			2010			2011			2010
Fair value hedges
Interest rate contracts
Net interest settlements and accruals excluded from the assessment of hedge effectiveness	$	67		$	52		$	133		$	105
Ineffectiveness (a)	2			2			(16		)	0
Total	$	69		$	54		$	117		$	105
Derivatives not designated as hedging instruments
Interest rate contracts	$	(4	)	$	(7	)	$	(6	)	$	12
Foreign exchange forward contracts (b)	6			57			(1		)	(3		)
Cross currency interest rate swap contracts (b)	(17		)	96			(31		)	88
Other (c)	2			0			2			0
Total	$	(13	)	$	146		$	(36	)	$	97

(a) For the second quarter of 2011 and 2010, hedge ineffectiveness reflects change in fair value on derivatives of $134 million gain and $112 million gain, respectively, and change in fair value on hedged debt of $132 million loss and $110 million loss, respectively. For the first half of 2011 and 2010, hedge ineffectiveness reflects a $46 million gain and a $155 million gain on derivatives, respectively, and a $62 million loss and $155 million loss on hedged debt, respectively.

(b) Gains/(Losses) related to foreign currency derivatives were substantially offset by net revaluation impacts on foreign denominated debt, which were also recorded in Other income, net.

(c) Reflects gains/(losses) for derivative features included in the FUEL notes (see Note 10).

For our fair value hedges, net interest settlements and accruals are excluded from the assessment of hedge effectiveness. We report net interest settlements and accruals in Interest expense.We report hedge ineffectiveness on fair value hedges and foreign currency revaluation on accrued interest in Other income, net. We report all income items on derivatives not designated as hedging instruments in Other income, net.

NOTE 11. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES (Continued)

Balance Sheet Effect of Derivative Financial Instruments

The following tables summarize the notional amounts and estimated fair value of our derivative financial instruments (in millions):

	June 30, 2011						December 31, 2010
	Notional		Fair Value Assets		Fair Value Liabilities		Notional		Fair Value Assets		Fair Value Liabilities
Fair value hedges
Interest rate contracts	$	7,850	$	260	$	—	$	8,826	$	503	$	7
Derivatives not designated as hedging instruments
Interest rate contracts	$	63,278	$	640	$	205	$	52,698	$	685	$	322
Foreign exchange forward contracts (a)	7,009		73		41		3,309		33		16
Cross currency interest rate swap contracts	1,114		—		42		1,472		25		189
Other (b)	2,500		75		—		—		—		—
Total derivatives not designated as hedging instruments	73,901		788		288		57,479		743		527
Total derivative financial instruments	$	81,751	$	1,048	$	288	$	66,305	$	1,246	$	534

(a) Includes forward contracts between Ford Credit and an affiliated company.

(b) Represents derivative features included in the FUEL notes (see Note 10).

We report derivative assets and derivative liabilities in Derivative financial instruments in our consolidated balance sheet. To ensure consistency in our treatment of derivative and non-derivative exposures with regard to our master agreements, we do not net our derivative position by counterparty for purposes of balance sheet presentation and disclosure.

The notional amounts of the derivative financial instruments do not represent amounts exchanged by the parties and, therefore, are not a direct measure of our exposure to the financial risks described above. The amounts exchanged are calculated by reference to the notional amounts and by other terms of the derivatives, such as interest rates or foreign currency exchange rates.

Counterparty Risk

Use of derivatives exposes us to the risk that a counterparty may default on a derivative contract. We establish exposure limits for each counterparty to minimize this risk and provide counterparty diversification. Substantially all of our derivative exposures are with counterparties that have long-term credit ratings of single-A or better. The aggregate fair value of derivative instruments in asset positions at June 30, 2011 was $1.0 billion, representing the maximum loss we would recognize at that date if all counterparties failed to perform as contracted. We enter into master agreements with counterparties that generally allow for netting of certain exposures; therefore, the actual loss we would recognize if all counterparties failed to perform as contracted would be significantly lower.

We include an adjustment for non-performance risk in the fair value of derivative instruments. Our adjustment for non-performance risk relative to a measure based on an unadjusted inter-bank deposit rate (e.g., LIBOR) increased our derivative assets by $3 million and decreased our derivative assets by $9 million at June 30, 2011 and December 31, 2010, respectively, and decreased our derivative liabilities by $3 million and $4 million at June 30, 2011 and December 31, 2010, respectively. See Note 10 for additional information regarding fair value measurements.