Derivative Financial Instruments

9 Months Ended

Sep. 30, 2011

Derivative Financial Instruments

Derivative Financial Instruments

6. Derivative Financial Instruments: The company operates in multiple functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity and commodity price changes and client credit risk. The company limits these risks by following established risk management policies and procedures, including the use of derivatives, and, where cost effective, financing with debt in the currencies in which assets are denominated. For interest rate exposures, derivatives are used to better align rate movements between the interest rates associated with the company’s lease and other financial assets and the interest rates associated with its financing debt. Derivatives are also used to manage the related cost of debt. For foreign currency exposures, derivatives are used to better manage the cash flow volatility arising from foreign exchange rate fluctuations.

As a result of the use of derivative instruments, the company is exposed to the risk that counterparties to derivative contracts will fail to meet their contractual obligations. To mitigate the counterparty credit risk, the company has a policy of only entering into contracts with carefully selected major financial institutions based upon their credit ratings and other factors. The company’s established policies and procedures for mitigating credit risk on principal transactions include reviewing and establishing limits for credit exposure and continually assessing the creditworthiness of counterparties. The right of set-off that exists under certain of these arrangements enables the legal entities of the company subject to the arrangement to net amounts due to and from the counterparty reducing the maximum loss from credit risk in the event of counterparty default.

The company is also a party to collateral security arrangements with most of its major counterparties. These arrangements require the company to hold or post collateral (cash or U.S. Treasury securities) when the derivative fair values exceed contractually established thresholds. Posting thresholds can be fixed or can vary based on credit default swap pricing or credit ratings received from the major credit agencies. The aggregate fair value of all derivative instruments under these collateralized arrangements that were in a liability position at September 30, 2011 and December 31, 2010 was $90 million and $363 million, respectively. The company posted no collateral at September 30, 2011, and posted collateral of $9 million at December 31, 2010. Full collateralization of these agreements would be required in the event that the company’s credit rating falls below investment grade or if its credit default swap spread exceeds 250 basis points, as applicable, pursuant to the terms of the collateral security arrangements. The aggregate fair value of derivative instruments in net asset positions as of September 30, 2011 and December 31, 2010 was $1,391 million and $1,099 million, respectively. This amount represents the maximum exposure to loss at the reporting date as a result of the counterparties failing to perform as contracted. This exposure was reduced by $336 million and $475 million at September 30, 2011 and December 31, 2010, respectively, of liabilities included in master netting arrangements with those counterparties. Additionally, at September 30, 2011 and December 31, 2010, this exposure was reduced by $469 million and $88 million of collateral, respectively, received by the company.

The company does not offset derivative assets against liabilities in master netting arrangements nor does it offset receivables or payables recognized upon payment or receipt of cash collateral against the fair values of the related derivative instruments. No amount was recognized in other receivables at September 30, 2011 for the right to reclaim cash collateral. At December 31, 2010, $9 million was recognized in other receivables for the right to reclaim cash collateral. The amount recognized in accounts payable for the obligation to return cash collateral totaled $469 million and $88 million at September 30, 2011 and December 31, 2010, respectively. The company restricts the use of cash collateral received to rehypothecation, and therefore reports it in prepaid expenses and other current assets in the Consolidated Statement of Financial Position. No amount was rehypothecated at September 30, 2011. At December 31, 2010, $9 million was rehypothecated.

The company may employ derivative instruments to hedge the volatility in stockholders’ equity resulting from changes in currency exchange rates of significant foreign subsidiaries of the company with respect to the U.S. dollar. These instruments, designated as net investment hedges, expose the company to liquidity risk as the derivatives have an immediate cash flow impact upon maturity which is not offset by a cash flow from the translation of the underlying hedged equity. The company monitors this cash loss potential on an ongoing basis and may discontinue some of these hedging relationships by de-designating or terminating the derivative instrument in order to manage the liquidity risk. Although not designated as accounting hedges, the company may utilize derivatives to offset the changes in the fair value of the de-designated instruments from the date of de-designation until maturity.

In its hedging programs, the company uses forward contracts, futures contracts, interest-rate swaps and cross-currency swaps, depending upon the underlying exposure. The company is not a party to leveraged derivative instruments.

A brief description of the major hedging programs, categorized by underlying risk, follows.

Interest Rate Risk

Fixed and Variable Rate Borrowings

The company issues debt in the global capital markets, principally to fund its financing lease and loan portfolio. Access to cost-effective financing can result in interest rate mismatches with the underlying assets. To manage these mismatches and to reduce overall interest cost, the company uses interest-rate swaps to convert specific fixed-rate debt issuances into variable-rate debt (i.e., fair value hedges) and to convert specific variable-rate debt issuances into fixed-rate debt (i.e., cash flow hedges). At September 30, 2011 and December 31, 2010, the total notional amount of the company’s interest rate swaps was  $6.7 billion and $7.1 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2011 and December 31, 2010 was approximately 5.1 years and 5.7 years, respectively.

Forecasted Debt Issuance

The company is exposed to interest rate volatility on future debt issuances. To manage this risk, the company may use forward starting interest-rate swaps to lock in the rate on the interest payments related to the forecasted debt issuance. These swaps are accounted for as cash flow hedges. The company did not have any derivative instruments relating to this program outstanding at September 30, 2011 and December 31, 2010.

At September 30, 2011 and December 31, 2010, net losses of approximately $7 million and $13 million (before taxes), respectively, were recorded in accumulated other comprehensive income/(loss) in connection with cash flow hedges of the company’s borrowings. For both periods, $8 million of losses are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying transactions.

Foreign Exchange Risk

Long-Term Investments in Foreign Subsidiaries (Net Investment)

A large portion of the company’s foreign currency denominated debt portfolio is designated as a hedge of net investment in foreign subsidiaries to reduce the volatility in stockholders’ equity caused by changes in foreign currency exchange rates in the functional currency of major foreign subsidiaries with respect to the U.S. dollar. The company also uses cross-currency swaps and foreign exchange forward contracts for this risk management purpose. At September 30, 2011 and December 31, 2010, the total notional amount of derivative instruments designated as net investment hedges was $2.0 billion and $1.9 billion, respectively. The weighted-average remaining maturity of these instruments at September 30, 2011 and December 31, 2010 was approximately 0.2 years and 0.4 years, respectively.

In addition, at December 31, 2010, the company had liabilities of $221 million, representing the fair value of derivative instruments that were previously designated in qualifying net investment hedging relationships, but were de-designated prior to December 31, 2010; this amount is expected to mature over the next 12 months. The notional amount of these instruments at December 31, 2010 was $1.6 billion, including original and offsetting transactions. No similar instruments were outstanding at September 30, 2011.

Anticipated Royalties and Cost Transactions

The company’s operations generate significant nonfunctional currency, third-party vendor payments and intercompany payments for royalties and goods and services among the company’s non-U.S. subsidiaries and with the parent company. In anticipation of these foreign currency cash flows and in view of the volatility of the currency markets, the company selectively employs foreign exchange forward contracts to manage its currency risk. These forward contracts are accounted for as cash flow hedges. The maximum length of time over which the company is hedging its exposure to the variability in future cash flows is 3.9 years. At September 30, 2011 and December 31, 2010, the total notional amount of forward contracts designated as cash flow hedges of forecasted royalty and cost transactions was $11.2 billion and $11.3 billion, respectively, with a weighted-average remaining maturity of 0.6 years and 0.8 years, respectively.

At September 30, 2011 and December 31, 2010, in connection with cash flow hedges of anticipated royalties and cost transactions, the company recorded net gains of $183 million and net losses of $147 million (before taxes), respectively, in accumulated other comprehensive income/(loss). Within these amounts $195 million of gains and $249 million of losses, respectively, are expected to be reclassified to net income within the next 12 months, providing an offsetting economic impact against the underlying anticipated transactions.

Foreign Currency Denominated Borrowings

The company is exposed to exchange rate volatility on foreign currency denominated debt. To manage this risk, the company employs cross-currency swaps to convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. These swaps are accounted for as cash flow hedges. The maximum length of time over which the company is hedging its exposure to the variability in future cash flows is 2.3 years.

At September 30, 2011 and December 31, 2010, the total notional amount of cross-currency swaps designated as cash flow hedges of foreign currency denominated debt was $0.1 billion and $0.2 billion, respectively.

At September 30, 2011 and December 31, 2010, net losses of approximately $2 million and $1 million (before taxes), respectively, were recorded in accumulated other comprehensive income/(loss) in connection with cash flow hedges of the company’s borrowings. Within these amounts approximately $1 million of losses are expected to be reclassified to net income within the next 12 months for both periods, providing an offsetting economic impact against the underlying transactions.

Subsidiary Cash and Foreign Currency Asset/Liability Management

The company uses its Global Treasury Centers to manage the cash of its subsidiaries. These centers principally use currency swaps to convert cash flows in a cost-effective manner. In addition, the company uses foreign exchange forward contracts to economically hedge, on a net basis, the foreign currency exposure of a portion of the company’s nonfunctional currency assets and liabilities. The terms of these forward and swap contracts are generally less than two years. The changes in the fair values of these contracts and of the underlying hedged exposures are generally offsetting and are recorded in other (income) and expense in the Consolidated Statement of Earnings. At September 30, 2011 and December 31, 2010, the total notional amount of derivative instruments in economic hedges of foreign currency exposure was $9.6 billion and $13.0 billion, respectively.

Equity Risk Management

The company is exposed to market price changes in certain broad market indices and in the company’s own stock primarily related to certain obligations to employees. Changes in the overall value of these employee compensation obligations are recorded in selling, general and administrative (SG&A) expense in the Consolidated Statement of Earnings. Although not designated as accounting hedges, the company utilizes derivatives, including equity swaps and futures, to economically hedge the exposures related to its employee compensation obligations. The derivatives are linked to the total return on certain broad market indices or the total return on the company’s common stock. They are recorded at fair value with gains or losses also reported in SG&A expense in the Consolidated Statement of Earnings. At September 30, 2011 and December 31, 2010, the total notional amount of derivative instruments in economic hedges of these compensation obligations was $0.9 billion and $1.0 billion, respectively.

Other Risks

The company may hold warrants to purchase shares of common stock in connection with various investments that are deemed derivatives because they contain net share or net cash settlement provisions. The company records the changes in the fair value of these warrants in other (income) and expense in the Consolidated Statement of Earnings. The company did not have any warrants qualifying as derivatives outstanding at September 30, 2011 and December 31, 2010.

The company is exposed to a potential loss if a client fails to pay amounts due under contractual terms. The company utilizes credit default swaps to economically hedge its credit exposures. These derivatives have terms of one year or less. The swaps are recorded at fair value with gains and losses reported in other (income) and expense in the Consolidated Statement of Earnings. The company did not have any derivative instruments relating to this program outstanding at September 30, 2011 and December 31, 2010.

The following tables provide a quantitative summary of the derivative and non-derivative instrument related risk management activity as of September 30, 2011 and December 31, 2010 as well as for the three months and nine months ended September 30, 2011 and 2010, respectively:

Fair Values of Derivative Instruments in the Consolidated Statement of Financial Position

As of September 30, 2011 and December 31, 2010

	Fair Value of Derivative Assets					Fair Value of Derivative Liabilities
	Balance Sheet					Balance Sheet
(Dollars in millions)	Classification	9/30/2011		12/31/2010		Classification	9/30/2011		12/31/2010
Designated as hedging instruments:
Interest rate contracts:	Prepaid expenses and other current assets	$	26	$	33	Other accrued expenses and liabilities	$	—	$	—
	Investments and sundry assets	870		514		Other liabilities	—		—
Foreign exchange contracts:	Prepaid expenses and other current assets	358		224		Other accrued expenses and liabilities	363		498
	Investments and sundry assets	4		22		Other liabilities	112		135
Fair value of derivative assets		$	1,257	$	794	Fair value of derivative liabilities	$	475	$	633
Not designated as hedging instruments:
Foreign exchange contracts:	Prepaid expenses and other current assets	$	101	$	242	Other accrued expenses and liabilities	$	60	$	370
	Investments and sundry assets	26		51		Other liabilities	—		—
Equity contracts:	Prepaid expenses and other current assets	7		12		Other accrued expenses and liabilities	25		3
Fair value of derivative assets		$	134	$	305	Fair value of derivative liabilities	$	84	$	373
Total debt designated as hedging instruments:
Short-term debt		N/A		N/A			$	808	$	823
Long-term debt		N/A		N/A			1,915		1,746
Total		$	1,391	$	1,099		$	3,282	$	3,576

N/A—not applicable

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

For the three months ended September 30, 2011 and 2010

	Gain (Loss) Recognized in Earnings
	Consolidated	Recognized on					Attributable to Risk
(Dollars in millions)	Statement of	Derivatives(1)					Being Hedged(2)
For the three months ended September 30:	Earnings Line Item	2011			2010		2011			2010
Derivative instruments in fair value hedges:
Interest rate contracts	Cost of financing	$	204		$	135	$	(166	)	$	(90	)
	Interest expense	141			86		(115		)	(58		)
Derivative instruments not designated as hedging instruments:(1)
Foreign exchange contracts	Other (income) and expense	183			584		N/A			N/A
Equity contracts	SG&A expense	(100		)	76		N/A			N/A
Warrants	Other (income) and expense	10			—		N/A			N/A
Total		$	438		$	881	$	(281	)	$	(148	)

	Gain (Loss) Recognized in Earnings and Other Comprehensive Income
													Ineffectiveness and
	Effective Portion					Consolidated	Effective Portion Reclassified						Amounts Excluded from
For the three months ended	Recognized in AOCI					Statement of	from AOCI to Earnings						Effectiveness Testing(3)
September 30:	2011		2010			Earnings Line Item	2011			2010			2011			2010
Derivative instruments in cash flow hedges:
Interest rate contracts	$	—	$	—		Interest expense	$	(2	)	$	(2	)	$	—		$	—
Foreign exchange contracts	295		(927		)	Other (income) and expense	(86		)	(5		)	(2		)	4
						Cost of sales	(60		)	1			—			—
						SG&A expense	(19		)	(2		)	—			—
Instruments in net investment hedges(4):
Foreign exchange contracts	237		(440		)	Interest expense	—			0			(4		)	1
Total	$	532	$	(1,367	)		$	(167	)	$	(7	)	$	(6	)	$	5

Note: AOCI represents Accumulated other comprehensive income/(loss) in the Consolidated Statement of Changes in Equity.

(1) The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.

(2) The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.

(3) The amount of gain/(loss) recognized in income represents ineffectiveness on hedge relationships.

(4) Instruments in net investment hedges include derivative and non-derivative instruments.

The Effect of Derivative Instruments in the Consolidated Statement of Earnings

For the nine months ended September 30, 2011 and 2010

	Gain (Loss) Recognized in Earnings
	Consolidated	Recognized on					Attributable to Risk
(Dollars in millions)	Statement of	Derivatives(1)					Being Hedged(2)
For the nine months ended September 30:	Earnings Line Item	2011			2010		2011			2010
Derivative instruments in fair value hedges:
Interest rate contracts	Cost of financing	$	263		$	382	$	(142	)	$	(251	)
	Interest expense	183			245		(99		)	(161		)
Derivative instruments not designated as hedging instruments:(1)
Foreign exchange contracts	Other (income) and expense	388			279		N/A			N/A
Equity contracts	SG&A expense	(28		)	34		N/A			N/A
Warrants	Other (income) and expense	10			—		N/A			N/A
Total		$	816		$	940	$	(241	)	$	(412	)

	Gain (Loss) Recognized in Earnings and Other Comprehensive Income
													Ineffectiveness and
	Effective Portion					Consolidated	Effective Portion Reclassified						Amounts Excluded from
For the nine months ended	Recognized in AOCI					Statement of	from AOCI to Earnings						Effectiveness Testing(3)
September 30:	2011			2010		Earnings Line Item	2011			2010			2011			2010
Derivative instruments in cash flow hedges:
Interest rate contracts	$	—		$	—	Interest expense	$	(6	)	$	(6	)	$	—		$	—
Foreign exchange contracts	(159		)	464		Other (income) and expense	(256		)	(19		)	(2		)	(3		)
						Cost of sales	(163		)	(81		)	—			—
						SG&A expense	(70		)	(46		)	—			—
Instruments in net investment hedges(4):
Foreign exchange contracts	(15		)	147		Interest expense	—			0			(10		)	1
Total	$	(174	)	$	611		$	(494	)	$	(152	)	$	(12	)	$	(2	)

Note: AOCI represents Accumulated other comprehensive income/(loss) in the Consolidated Statement of Changes in Equity.

(1) The amount includes changes in clean fair values of the derivative instruments in fair value hedging relationships and the periodic accrual for coupon payments required under these derivative contracts.

(2) The amount includes basis adjustments to the carrying value of the hedged item recorded during the period and amortization of basis adjustments recorded on de-designated hedging relationships during the period.

(3) The amount of gain/(loss) recognized in income represents ineffectiveness on hedge relationships.

(4) Instruments in net investment hedges include derivative and non-derivative instruments.

For the three and nine months ending September 30, 2011 and 2010, there were no significant gains or losses recognized in earnings representing hedge ineffectiveness or excluded from the assessment of hedge effectiveness (for fair value hedges), or associated with an underlying exposure that did not or was not expected to occur (for cash flow hedges); nor are there any anticipated in the normal course of business.

Refer to the 2010 IBM Annual Report, Note A, “Significant Accounting Policies,” on pages 75 and 76 for additional information on the company’s use of derivative financial instruments.