FINANCIAL INSTRUMENTS

The Company maintains an investment portfolio of various holdings, types, and maturities. The Company’s mutual funds, which are related to the Company’s obligations under the deferred compensation plan, are classified as trading securities. Investments classified as trading securities are recorded at fair value based upon quoted market prices. Differences between the cost and fair value of trading securities are recognized as other income (expense) in the Condensed Consolidated Statements of Operations. All of the Company’s other investments are classified as available-for-sale and consequently are recorded in the Condensed Consolidated Balance Sheets at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss), net of tax.

Fair Value

The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact, and it considers assumptions that market participants would use when pricing the asset or liability.

A fair value hierarchy has been established that prioritizes the inputs to valuation techniques used to measure fair value. The level of an asset or liability in the hierarchy is based on the lowest level of input that is significant to the fair value measurement. Assets and liabilities carried at fair value are classified and disclosed in one of the following three categories:

Level 1: Valuations based on quoted prices in active markets for identical assets or liabilities with sufficient volume and frequency of transactions.

Level 2: Valuations based on observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or model-derived valuations techniques for which all significant inputs are observable in the market or can be corroborated by observable market data, for substantially the full term of the assets or liabilities.

Level 3: Valuations based on unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities and based on non-binding, broker-provided price quotes and may not have been corroborated by observable market data.

The Company’s primary financial instruments include its cash, cash equivalents, investments, restricted cash and investments, long-term investments, accounts receivable, accounts payable, long-term debt and capital leases, and foreign currency related derivative instruments. The estimated fair value of cash, accounts receivable and accounts payable approximates their carrying value due to the short period of time to their maturities. The estimated fair values of capital lease obligations approximate their carrying value as the substantial majority of these obligations have interest rates that adjust to market rates on a periodic basis. Refer to Note 11 for additional information regarding the fair value of the Company’s Senior Notes and Convertible Notes.

The following table sets forth the Company’s cash, cash equivalents, investments, restricted cash and investments, and other assets measured at fair value on a recurring basis as of December 25, 2016 and June 26, 2016:



	December 25, 2016
										(Reported Within)
	Cost		Unrealized Gain		Unrealized (Loss)			Fair Value		Cash and Cash Equivalents		Investments		Restricted Cash & Investments		Other Assets
	(in thousands)
Cash	$	615,922	$	—	$	—		$	615,922	$	610,775	$	—	$	5,147	$	—
Level 1:
Time Deposit	728,810		—		—			728,810		478,782		—		250,028		—
Money Market Funds	1,233,602		—		—			1,233,602		1,233,602		—		—		—
U.S. Treasury and Agencies	811,564		39		(4,720		)	806,883		88,982		717,901		—		—
Mutual Funds	40,889		1,613		—			42,502		—		—		—		42,502
Level 1 Total	2,814,865		1,652		(4,720		)	2,811,797		1,801,366		717,901		250,028		42,502
Level 2:
Municipal Notes and Bonds	134,838		48		(115		)	134,771		—		134,771		—		—
Government-Sponsored Enterprises	31,357		—		(42		)	31,315		—		31,315		—		—
Foreign Government Bonds	30,605		—		(177		)	30,428		1,154		29,274		—		—
Corporate Notes and Bonds	2,361,859		542		(7,563		)	2,354,838		80,167		2,274,671		—		—
Mortgage Backed Securities — Residential	98,869		42		(975		)	97,936		10,498		87,438		—		—
Mortgage Backed Securities — Commercial	54,266		4		(215		)	54,055		—		54,055		—		—
Level 2 Total	2,711,794		636		(9,087		)	2,703,343		91,819		2,611,524		—		—
Total	$	6,142,581	$	2,288	$	(13,807	)	$	6,131,062	$	2,503,960	$	3,329,425	$	255,175	$	42,502



	June 26, 2016
										(Reported Within)
	Cost		Unrealized Gain		Unrealized (Loss)			Fair Value		Cash and Cash Equivalents		Investments		Restricted Cash & Investments		Other Assets
	(in thousands)
Cash	$	418,216	$	—	$	—		$	418,216	$	412,573	$	—	$	5,643	$	—
Level 1:
Time Deposit	904,243		—		—			904,243		659,465		—		244,778		—
Money Market Funds	3,904,288		—		—			3,904,288		3,904,288		—		—		—
U.S. Treasury and Agencies	446,530		2,041		(2		)	448,569		62,996		385,573		—		—
Mutual Funds	39,318		1,400		(397		)	40,321		—		—		—		40,321
Level 1 Total	5,294,379		3,441		(399		)	5,297,421		4,626,749		385,573		244,778		40,321
Level 2:
Municipal Notes and Bonds	265,386		355		(16		)	265,725		—		265,725		—		—
U.S. Treasury and Agencies	8,068		151		—			8,219		—		8,219		—		—
Government-Sponsored Enterprises	31,885		91		(13		)	31,963		—		31,963		—		—
Foreign Government Bonds	41,440		76		(4		)	41,512		—		41,512		—		—
Corporate Notes and Bonds	979,566		4,341		(566		)	983,341		—		983,341		—		—
Mortgage Backed Securities — Residential	17,395		37		(152		)	17,280		—		17,280		—		—
Mortgage Backed Securities — Commercial	55,129		30		(160		)	54,999		—		54,999		—		—
Level 2 Total	1,398,869		5,081		(911		)	1,403,039		—		1,403,039		—		—
Total	$	7,111,464	$	8,522	$	(1,310	)	$	7,118,676	$	5,039,322	$	1,788,612	$	250,421	$	40,321

The Company accounts for its investment portfolio at fair value. Realized gains (losses) for investment sales are specifically identified. Management assesses the fair value of investments in debt securities that are not actively traded through consideration of interest rates and their impact on the present value of the cash flows to be received from the investments. The Company also considers whether changes in the credit ratings of the issuer could impact the assessment of fair value. The Company did not recognize any losses on investments due to other-than-temporary impairments during the three and six months ended December 25, 2016 or December 27, 2015. Additionally, gross realized gains and gross realized (losses) from sales of investments were approximately $0.1 million and $(0.4) million, respectively, in the three months ended December 25, 2016 and $0.6 million and $(1.4) million, respectively, in the three months ended December 27, 2015. Gross realized gains and gross realized (losses) from sales of investments were approximately $2.7 million and $(0.6) million, respectively, in the six months ended December 25, 2016 and $0.8 million and $(2.0) million, respectively, in the six months ended December 27, 2015.

The following is an analysis of the Company’s cash, cash equivalents, investments, and restricted cash and investments in unrealized loss positions:



	December 25, 2016
	Unrealized Losses Less Than 12 Months					Unrealized Losses 12 Months or Greater					Total
	Fair Value		Gross Unrealized Loss			Fair Value		Gross Unrealized Loss			Fair Value		Gross Unrealized Loss
	(in thousands)
Municipal Notes and Bonds	$	99,754	$	(111	)	$	1,996	$	(4	)	$	101,750	$	(115	)
U.S. Treasury & Agencies	684,419		(4,720		)	—		—			684,419		(4,720		)
Government-Sponsored Enterprises	30,627		(26		)	564		(16		)	31,191		(42		)
Foreign Government Bonds	26,189		(177		)	—		—			26,189		(177		)
Corporate Notes and Bonds	1,617,323		(7,476		)	34,456		(87		)	1,651,779		(7,563		)
Mortgage Backed Securities — Residential	75,601		(818		)	10,038		(157		)	85,639		(975		)
Mortgage Backed Securities — Commercial	44,494		(181		)	7,138		(34		)	51,632		(215		)
	$	2,578,407	$	(13,509	)	$	54,192	$	(298	)	$	2,632,599	$	(13,807	)

The amortized cost and fair value of cash equivalents, investments and restricted investments with contractual maturities are as follows as of December 25, 2016:



	Cost		Estimated Fair Value
	(in thousands)
Due in one year or less	$	3,036,400	$	3,035,906
Due after one year through five years	2,333,026		2,320,918
Due in more than five years	116,344		115,814
	$	5,485,770	$	5,472,638

The Company has the ability, if necessary, to liquidate its investments in order to meet the Company’s liquidity needs in the next 12 months. Accordingly, those investments with contractual maturities greater than one year from the date of purchase nonetheless are classified as short-term on the accompanying Condensed Consolidated Balance Sheets.

Derivative Instruments and Hedging

The Company carries derivative financial instruments (“Derivatives”) on its Condensed Consolidated Balance Sheets at their fair values. The Company enters into foreign currency forward derivative contracts and foreign currency options with financial institutions with the primary objective of reducing volatility of earnings and cash flows related to foreign currency exchange rate fluctuations. The counterparties to these derivative contracts are large global financial institutions that the Company believes are creditworthy, and therefore, it does not consider the risk of counterparty nonperformance to be material.

Cash Flow Hedges

The Company’s financial position is routinely subjected to market risk associated with foreign currency exchange rate fluctuations on non-U.S. dollar transactions or cash flows, primarily from Japanese yen-denominated revenues, and euro denominated and Korean won-denominated expenses. The Company’s policy is to mitigate the foreign exchange risk arising from the fluctuations in the value of these non-U.S. dollar denominated transactions or cash flows through a foreign currency cash flow hedging program, using forward contracts and foreign currency options that generally expire within 12 months and no later than 24 months. These hedge contracts are designated as cash flow hedges and are carried on the Company’s balance sheet at fair value with the effective portion of the contracts’ gains or losses included in accumulated other comprehensive income (loss) and subsequently recognized in revenue/expense in the same period the hedged items are recognized.

In addition, during the year ended June 26, 2016, the Company entered into and settled forward-starting interest rate swap agreements to hedge against the variability of cash flows due to changes in certain benchmark interest rates on fixed rate debt. These instruments are designated as cash flow hedges at inception and are settled in conjunction with the issuance of debt. The effective portion of the contracts’ gain or loss is included in accumulated other comprehensive (loss) and is amortized into income as the hedged item impacts earnings.

At inception and at each quarter end, hedges are tested prospectively and retrospectively for effectiveness using regression analysis. Changes in the fair value of the forward contracts due to changes in time value are excluded from the assessment of effectiveness and are recognized in revenue or expense in the current period. The change in time value related to these contracts was not material for all reported periods. Changes in the fair value of foreign exchange options due to changes in time value are included in the assessment of effectiveness. To qualify for hedge accounting, the hedge relationship must meet criteria relating both to the derivative instrument and the hedged item. These criteria include identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value or cash flows will be measured. There were no material gains or losses during the three or six months ended December 25, 2016 and December 27, 2015 associated with ineffectiveness or forecasted transactions that failed to occur.

To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedge and the hedges must be tested to demonstrate an expectation of providing highly effective offsetting changes to future cash flows on hedged transactions. When derivative instruments are designated and qualify as effective cash flow hedges, the Company recognizes effective changes in the fair value of the hedging instrument within accumulated other comprehensive income (loss) until the hedged exposure is realized. Consequently, with the exception of excluded time value associated with the forward contracts and hedge ineffectiveness recognized, the Company’s results of operations are not subject to fluctuation as a result of changes in the fair value of the derivative instruments. If hedges are not highly effective or if the Company does not believe that the underlying hedged forecasted transactions will occur, the Company may not be able to account for its derivative instruments as cash flow hedges. If this were to occur, future changes in the fair values of the Company’s derivative instruments would be recognized in earnings. Additionally, related amounts previously recorded in other comprehensive income would be reclassified to income immediately. As of December 25, 2016, the Company had gains of $10.5 million accumulated in other comprehensive income, net of tax, related to foreign exchange cash flow hedges which it expects to reclassify from other comprehensive income into earnings over the next 12 months. Additionally, the Company had a net loss of $1.9 million accumulated in other comprehensive income, net of tax, related to interest rate contracts which it expects to reclassify from other comprehensive income into earnings over the next 8.2 years. As a result of the October 5, 2016 termination of the Agreement and Plan of Merger and Reorganization with KLA-Tencor Corporation ("KLA-Tencor") (see Note 15 for additional information), a gain of approximately $1.1 million accumulated in other comprehensive income, net of tax, related to interest rate contracts associated with the 2026 Notes (as defined in Note 11) were reclassified into earnings in the three months ended December 25, 2016.

Fair Value Hedges

During the fiscal year ended June 26, 2016, the Company entered into a series of interest rate contracts with a total notional value of $400 million whereby the Company receives fixed rates and pays variable rates based on certain benchmark interest rates, resulting in a net increase or decrease to interest expense, a component of Other expense, net in our Condensed Consolidated Statement of Operations. These interest rate contracts are designated as fair value hedges and hedge against changes in the fair value of our debt portfolio. The Company concluded that these interest rate contracts meet the criteria necessary to qualify for the short-cut method of hedge accounting, and as such an assumption is made that the change in the fair value of the hedged debt, due to changes in the benchmark rate, exactly offsets the change in the fair value of the interest rate swap. Therefore, the derivative is considered to be effective at achieving offsetting changes in the fair value of the hedged liability, and no ineffectiveness is recognized.

Balance Sheet Hedges

The Company also enters into foreign currency forward contracts to hedge fluctuations associated with foreign currency denominated monetary assets and liabilities, primarily third party accounts receivables, accounts payables and intercompany receivables and payables. These forward contracts are not designated for hedge accounting treatment. Therefore, the change in fair value of these derivatives is recorded as a component of other income (expense) and offsets the change in fair value of the foreign currency denominated assets and liabilities, which are also recorded in other income (expense).

As of December 25, 2016, the Company had the following outstanding foreign currency contracts that were entered into under its cash flow and balance sheet hedge program:



	Notional Value
	Derivatives Designated as Hedging Instruments:				Derivatives Not Designated as Hedging Instruments:
	(in thousands)
Foreign Currency Forward Contracts
	Buy Contracts		Sell Contracts		Buy Contracts		Sell Contracts
Japanese yen	$	—	$	235,891	$	—	$	45,498
Swiss franc	—		—		8,740		—
Euro	39,463		—		20,608		—
Korean won	48,517		—		8,310		—
Chinese renminbi	—		—		8,203
Singapore dollar	—		—		20,732		—
Taiwan dollar	—		—		15,639		—
	$	87,980	$	235,891	$	82,232	$	45,498

The fair value of derivative instruments in the Company’s Condensed Consolidated Balance Sheets as of December 25, 2016 and June 26, 2016 were as follows:



	December 25, 2016						June 26, 2016
	Fair Value of Derivative Instruments (Level 2)						Fair Value of Derivative Instruments (Level 2)
	Asset Derivatives			Liability Derivatives			Asset Derivatives			Liability Derivatives
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
	(in thousands)
Derivatives designated as hedging instruments:
Foreign exchange forward contracts	Prepaid expense and other assets	$	13,432	Accrued liabilities	$	847	Prepaid expense and other assets	$	249	Accrued liabilities	$	16,585
Interest rate contracts, short-term	Accrued expenses and other current liabilities	—		Prepaid expense and other assets	2,024		Accrued expenses and other current liabilities	50		Prepaid expense and other assets	159
Interest rate contracts, long-term	Other assets	—		Other long-term liabilities	17,152		Other assets	8,661		Other long-term liabilities	—
Derivatives not designated as hedging instruments:
Foreign exchange forward contracts	Prepaid expense and other assets	34		Accrued liabilities	117		Prepaid expense and other assets	107		Accrued liabilities	1,529
Total Derivatives		$	13,466		$	20,140		$	9,067		$	18,273

Under the master netting agreements with the respective counterparties to the Company’s derivative contracts, subject to applicable requirements, the Company is allowed to net settle transactions of the same currency with a single net amount payable by one party to the other. However, the Company has elected to present the derivative assets and derivative liabilities on a gross basis on its balance sheet. As of December 25, 2016, the potential effect of rights of off-set associated with the above foreign exchange and interest rate contracts would be an offset to assets and liabilities by $3.5 million, resulting in a net derivative asset of $10.0 million and net derivative liability of $16.7 million. As of June 26, 2016, the potential effect of rights of set-off associated with the above foreign exchange contracts would be an offset to both assets and liabilities by $6.4 million, resulting in a net derivative asset of $2.7 million and a net derivative liability of $11.9 million. The Company is not required to pledge, nor is the Company entitled to receive, cash collateral for these derivative transactions.

The effect of derivative instruments designated as cash flow hedges on the Company’s Condensed Consolidated Statements of Operations, including accumulated other comprehensive income (“AOCI”) was as follows:



		Three Months Ended December 25, 2016										Six Months Ended December 25, 2016
		Effective Portion						Ineffective Portion and Amount Excluded from Effectiveness				Effective Portion							Ineffective Portion and Amount Excluded from Effectiveness
	Location of Gain (Loss) Recognized in or Reclassified into Income	Gain (Loss) Recognized in AOCI			Gain (Loss) Reclassified from AOCI into Income				Gain (Loss) Recognized in Income			Gain (Loss) Recognized in AOCI			Gain (Loss) Reclassified from AOCI into Income				Gain (Loss) Recognized in Income
Derivatives Designated as Hedging Instruments		(in thousands)
Foreign Exchange Contracts	Revenue	$	18,138		$	(420	)		$	708		$	15,225			$	(14,025	)		$	1,413
Foreign Exchange Contracts	Cost of goods sold	(786		)	(180		)		(28		)	(551		)		(7		)		(95		)
Foreign Exchange Contracts	Selling, general, and administrative	(348		)	(146		)		(15		)	(372		)		(155		)		(36		)
Foreign Exchange Contracts	Other expense, net	—			—				3			—				—				3
Interest Rate Contracts	Other expense, net	—			1,778				—			—				1,787				—
		$	17,004		$	1,032			$	668		$	14,302			$	(12,400	)		$	1,285



		Three Months Ended December 27, 2015											Six Months Ended December 27, 2015
		Effective Portion							Ineffective Portion and Amount Excluded from Effectiveness				Effective Portion							Ineffective Portion and Amount Excluded from Effectiveness
	Location of Gain (Loss) Recognized in or Reclassified into Income	Gain (Loss) Recognized in AOCI			Gain (Loss) Reclassified from AOCI into Income				Gain (Loss) Recognized in Income				Gain (Loss) Recognized in AOCI			Gain (Loss) Reclassified from AOCI into Income				Gain (Loss) Recognized in Income
Derivatives Designated as Hedging Instruments
Foreign Exchange Contracts	Revenue	$	4,256			$	(4,808	)		$	215		$	4,187			$	(6,186	)		247
Foreign Exchange Contracts	Cost of goods sold	(223		)		1,052				(14		)	(638		)		2,557				(36	)
Foreign Exchange Contracts	Selling, general, and administrative	147				111				(12		)	(26		)		369				(19	)
Interest Rate Contracts	Other expense, net	—				(95		)		—			—				(189		)		—
		$	4,180			$	(3,740	)		$	189		$	3,523			$	(3,449	)		192

The effect of derivative instruments not designated as cash flow hedges on the Company’s Condensed Consolidated Statements of Operations was as follows:

Three Months Ended

Six Months Ended

December 25,
2016

December 27,
2015

December 25, 2016

December 27, 2015

Derivatives Not Designated as Hedging Instruments:

Location
of Gain
Recognized
in Income

Gain
Recognized
in Income

(in thousands)

Foreign Exchange Contracts

Other
income

4,343

1,561

3,960

7,568

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, investments, restricted cash and investments, trade accounts receivable, and derivative financial instruments used in hedging activities. Cash is placed on deposit at large global financial institutions. Such deposits may be in excess of insured limits. Management believes that the financial institutions that hold the Company’s cash are creditworthy and, accordingly, minimal credit risk exists with respect to these balances.

The Company’s overall portfolio of available-for-sale securities must maintain an average minimum rating of “AA-” or “Aa3” as rated by Standard and Poor’s, Moody’s Investor Services, or Fitch Ratings. To ensure diversification and minimize concentration, the Company’s policy limits the amount of credit exposure with any one financial institution or commercial issuer.

The Company is exposed to credit losses in the event of nonperformance by counterparties on foreign currency forward hedge contracts that are used to mitigate the effect of exchange rate fluctuations, and on contracts related to structured share repurchase arrangements. These counterparties are large global financial institutions and, to date, no such counterparty has failed to meet its financial obligations to the Company.

Credit risk evaluations, including trade references, bank references and Dun & Bradstreet ratings, are performed on all new customers and the Company monitors its customers’ financial condition and payment performance. In general, the Company does not require collateral on sales.