Derivative Financial Instruments and Hedging Activities

3 Months Ended

Mar. 31, 2014

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 that are used to manage the effects of interest rate fluctuations;

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

• Cross-currency interest rate swap contracts that 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 strategy on a regular basis.

Derivative assets and derivative liabilities are recorded in Derivative financial instruments on our balance sheet at fair value and presented on a gross basis.

We have elected to apply hedge accounting to certain derivatives. Derivatives that are designated in hedging relationships are evaluated for effectiveness using regression analysis at the time they are designated and throughout the hedge period. Cash flows and the 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, we only enter into transactions that we believe will be highly effective at offsetting the underlying economic risk. We report net interest settlements and accruals and changes in the fair value of derivatives not designated as hedging instruments in Other income, net. Cash flows associated with non-designated or de-designated derivatives are reported in Net cash provided by/(used in) investing activities in our statement of cash flows.

Fair Value Hedges. We use derivatives to reduce the risk of changes in the fair value of debt. 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.

Net interest settlements and accruals on fair value hedges are excluded from the assessment of hedge effectiveness. We report net interest settlements and accruals in Interest expense.We report foreign currency revaluation on accrued interest in Other income, net. The cash flows associated with fair value hedges are reported in Net cash provided by/(used in) operating activities in our statement of cash flows.

Hedge ineffectiveness is the difference between the change in fair value of the derivative instrument and the change in fair value of the hedged item attributable to changes in the benchmark interest rate. Ineffectiveness is recorded directly to income.

When a fair value hedge is de-designated, or when the derivative 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.

NOTE 7. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES (Continued)

Income Effect of Derivative Financial Instruments

The following table summarizes by hedge designation the pre-tax gains/(losses) recognized in income for the periods ended March 31 (in millions):

	First Quarter
	2014			2013
Fair value hedges
Interest rate contracts
Net interest settlements and accruals excluded from the assessment of hedge effectiveness	$	69		$	61
Ineffectiveness (a)	5			(6		)
Total	$	74		$	55
Derivatives not designated as hedging instruments
Interest rate contracts	$	(18	)	$	2
Foreign currency exchange contracts (b)	(5		)	75
Cross-currency interest rate swap contracts (b)	(5		)	138
Total	$	(28	)	$	215

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(a) For the first quarter of 2014 and 2013, hedge ineffectiveness reflects change in fair value on derivatives of $105 million gain and $91 million loss, respectively, and change in value on hedged debt attributable to the change in benchmark interest rate of $100 million loss and $85 million gain, respectively.

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

Balance Sheet Effect of Derivative Financial Instruments

The following table summarizes the notional amount and estimated fair value of our derivative financial instruments (in millions):

	March 31, 2014						December 31, 2013
	Notional		Fair Value of Assets		Fair Value of Liabilities		Notional		Fair Value of Assets		Fair Value of Liabilities
Fair value hedges
Interest rate contracts	$	18,637	$	338	$	175	$	18,778	$	360	$	179
Derivatives not designated as hedging instruments
Interest rate contracts	66,917		325		109		69,863		224		126
Foreign currency exchange contracts (a)	2,271		4		21		2,410		1		25
Cross-currency interest rate swap contracts	2,927		1		165		2,620		—		176
Total derivatives not designated as hedging instruments	72,115		330		295		74,893		225		327
Total derivative financial instruments	$	90,752	$	668	$	470	$	93,671	$	585	$	506

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

NOTE 7. DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES (Continued)

Notional amounts are presented on a gross basis. 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

The 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 an investment grade rating. The aggregate fair value of derivative instruments in asset positions at March 31, 2014 was $668 million, 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 may allow for netting of exposures in the event of default or termination of the counterparty agreement due to breach of contract.

The gross and net amounts of derivative assets and liabilities were as follows (in millions):

	March 31, 2014						December 31, 2013
	Fair Value of Assets			Fair Value of Liabilities			Fair Value of Assets			Fair Value of Liabilities
Gross derivative amounts recognized in the balance sheet	$	668		$	470		$	585		$	506
Gross derivative amounts not offset in the balance sheet that are eligible for offsetting	(307		)	(307		)	(296		)	(296		)
Net amount	$	361		$	163		$	289		$	210

We may receive or pledge cash collateral with certain counterparties based on our net position with regard to foreign currency derivative contracts. As of March 31, 2014 and December31, 2013, we did not receive or pledge any cash collateral.

We include an adjustment for non-performance risk in the measurement of fair value of derivative instruments. Our adjustment for non-performance risk is relative to a measure based on an unadjusted inter-bank deposit rate (e.g., LIBOR). At March 31, 2014 and December 31, 2013, our adjustment increased derivative assets by $2 million and $2 million, respectively, and decreased our derivative liabilities by $12 million and $25 million, respectively. See Note 12 for additional information regarding valuation methodologies.