Derivative Financial Instruments and Risk Management

Our earnings and cash flow are subject to fluctuations due to changes in foreign currency exchange rates and interest rates. Our Risk Management Policy (policy) allows for the use of derivative financial instruments to manage foreign currency exchange rate and interest rate exposures. Our policy specifies that derivatives are not to be used for speculative purposes. Derivatives that we use are primarily foreign currency forward, option and cross currency contracts and interest rate contracts. Our derivative activities are subject to the management, direction and control of our senior financial officers. We present at least annually to our Board of Directors and the Audit Committee of the Caterpillar Inc. Board of Directors on our risk management practices, including our use of financial derivative instruments.

We recognize all derivatives at their fair value on the Consolidated Statements of Financial Position. On the date the derivative contract is entered into, the derivative instrument is (1) designated as a hedge of the fair value of a recognized asset or liability (fair value hedge), (2) designated as a hedge of a forecasted transaction or the variability of cash flows (cash flow hedge) or (3) undesignated. We record in current earnings changes in the fair value of a derivative that is qualified, designated and highly effective as a fair value hedge, along with the gain or loss on the hedged recognized asset or liability that is attributable to the hedged risk. We record in Accumulated other comprehensive income (loss) (AOCI) changes in the fair value of a derivative that is qualified, designated and highly effective as a cash flow hedge, to the extent effective, on the Consolidated Statements of Financial Position until we reclassify them to earnings in the same period or periods during which the hedged transaction affects earnings. We report changes in the fair value of undesignated derivative instruments in current earnings. We classify cash flows from designated derivative financial instruments within the same category as the item being hedged on the Consolidated Statements of Cash Flows. We include cash flows from undesignated derivative financial instruments in the investing category on the Consolidated Statements of Cash Flows.

We formally document all relationships between hedging instruments and hedged items, as well as the risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value hedges to specific assets and liabilities on the Consolidated Statements of Financial Position and linking cash flow hedges to specific forecasted transactions or variability of cash flow.

We also formally assess, both at the hedge’s inception and on an ongoing basis, whether the designated derivatives that are used in hedging transactions are highly effective in offsetting changes in fair value or cash flow of hedged items. When a derivative is determined not to be highly effective as a hedge or the underlying hedged transaction is no longer probable, we discontinue hedge accounting prospectively in accordance with derecognition criteria for hedge accounting.

Foreign currency exchange rate risk

We have balance sheet positions and expected future transactions denominated in foreign currencies, thereby creating exposure to movements in exchange rates. In managing foreign currency risk, our objective is to minimize earnings volatility resulting from conversion and the remeasurement of net foreign currency balance sheet positions and future transactions denominated in foreign currencies. Our policy allows the use of foreign currency forward, option and cross currency contracts to offset the risk of currency mismatch between our assets and liabilities and exchange rate risk associated with future transactions denominated in foreign currencies. Our foreign currency forward and option contracts are primarily undesignated. We designate fixed-to-fixed cross currency contracts as cash flow hedges to protect against movements in exchange rates on foreign currency fixed-rate assets and liabilities.

Interest rate risk

Interest rate movements create a degree of risk by affecting the amount of our interest payments and the value of our fixed-rate debt. Our practice is to use interest rate contracts to manage our exposure to interest rate changes.

We have a match-funding policy that addresses interest rate risk by aligning the interest rate profile (fixed or floating rate and duration) of our debt portfolio with the interest rate profile of our finance receivable portfolio within predetermined ranges on an ongoing basis. In connection with that policy, we use interest rate derivative instruments to modify the debt structure to match assets within the finance receivable portfolio. This matched funding reduces the volatility of margins between interest-bearing assets and interest-bearing liabilities, regardless of which direction interest rates move.

Our policy allows us to use fixed-to-floating, floating-to-fixed and floating-to-floating interest rate contracts to meet the match-funding objective. We designate fixed-to-floating interest rate contracts as fair value hedges to protect debt against changes in fair value due to changes in the benchmark interest rate. We designate most floating-to-fixed interest rate contracts as cash flow hedges to protect against the variability of cash flows due to changes in the benchmark interest rate.

As of June 30, 2020, $16 million of deferred net losses, net of tax, included in equity (AOCI in the Consolidated Statements of Financial Position), related to our floating-to-fixed interest rate contracts, are expected to be reclassified to Interest expense over the next twelve months. The actual amount recorded in Interest expense will vary based on interest rates at the time the hedged transactions impact earnings.

As of June 30, 2020, the cumulative amount of fair value hedging adjustments related to our fixed-to-floating interest rate contracts included in the carrying amount of Long-term debt was $70 million. Fair value gains and losses on these interest rate contracts and the related hedged items generally offset within interest expense. We have, at certain times, liquidated fixed-to-floating interest rate contracts that resulted in deferred gains at the time of liquidation. The deferred gains associated with these interest rate contracts are included in Long-term debt in the Consolidated Statements of Financial Position and are being amortized to Interest expense over the remaining term of the previously designated hedged item.

The location and fair value of derivative instruments reported in the Consolidated Statements of Financial Position were as follows:



(Millions of dollars)		Asset (Liability) Fair Value
	Consolidated Statements of Financial Position Location	June 30, 2020			December 31, 2019
Designated derivatives
Interest rate contracts	Other assets	$	69		$	5
Interest rate contracts	Accrued expenses	(26		)	(25		)
Cross currency contracts	Other assets	57			67
Cross currency contracts	Accrued expenses	(3		)	(3		)
		$	97		$	44
Undesignated derivatives
Foreign exchange contracts	Other assets	$	49		$	7
Foreign exchange contracts	Accrued expenses	(12		)	(21		)
Cross currency contracts	Other assets	12			5
Cross currency contracts	Accrued expenses	—			(1		)
		$	49		$	(10	)

The total notional amount of our derivative instruments was $11.45 billion and $8.93 billion as of June 30, 2020 and December 31, 2019, respectively. The notional amounts of derivative financial instruments do not represent amounts exchanged by the parties. We calculate the amounts exchanged by the parties by referencing the notional amounts and by other terms of the derivatives, such as foreign currency exchange rates and interest rates.

The effect of derivatives designated as hedging instruments on the Consolidated Statements of Profit was as follows:



Cash Flow Hedges
(Millions of dollars)	Three Months Ended June 30, 2020
				Recognized in Earnings
	Amount of Gains (Losses) Recognized in AOCI			Classification	Amount of Gains (Losses) Reclassified from AOCI			Amount of the line items in the Consolidated Statements of Profit
Interest rate contracts	$	(9	)	Interest expense	$	(19	)	$	150
Cross currency contracts	(35		)	Other income (expense)	(43		)	(6		)
				Interest expense	9			150
	$	(44	)		$	(53	)

	Three Months Ended June 30, 2019
				Recognized in Earnings
	Amount of Gains (Losses) Recognized in AOCI			Classification	Amount of Gains (Losses) Reclassified from AOCI			Amount of the line items in the Consolidated Statements of Profit
Interest rate contracts	$	(34	)	Interest expense	$	—		$	200
Cross currency contracts	10			Other income (expense)	(4		)	(6		)
				Interest expense	7			200
	$	(24	)		$	3

	Six Months Ended June 30, 2020
				Recognized in Earnings
	Amount of Gains (Losses) Recognized in AOCI			Classification	Amount of Gains (Losses) Reclassified from AOCI			Amount of the line items in the Consolidated Statements of Profit
Interest rate contracts	$	(24	)	Interest expense	$	(24	)	$	325
Cross currency contracts	66			Other income (expense)	28			(16		)
				Interest expense	20			325
	$	42			$	24

	Six Months Ended June 30, 2019
				Recognized in Earnings
	Amount of Gains (Losses) Recognized in AOCI			Classification	Amount of Gains (Losses) Reclassified from AOCI			Amount of the line items in the Consolidated Statements of Profit
Interest rate contracts	$	(60	)	Interest expense	$	1		$	401
Cross currency contracts	32			Other income (expense)	2			(10		)
				Interest expense	14			401
	$	(28	)		$	17

The effect of derivatives not designated as hedging instruments on the Consolidated Statements of Profit was as follows:



(Millions of dollars)		Three Months Ended June 30,
	Classification	2020			2019
Foreign exchange contracts	Other income (expense)	$	(24	)	$	(9	)
Cross currency contracts	Other income (expense)	1			(1		)
		$	(23	)	$	(10	)

		Six Months Ended June 30,
	Classification	2020			2019
Foreign exchange contracts	Other income (expense)	$	75		$	(38	)
Cross currency contracts	Other income (expense)	10			(1		)
		$	85		$	(39	)

We enter into International Swaps and Derivatives Association (ISDA) master netting agreements that permit the net settlement of amounts owed under their respective derivative contracts. Under these master netting agreements, net settlement generally permits us or the counterparty to determine the net amount payable for contracts due on the same date and in the same currency for similar types of derivative transactions. The master netting agreements generally also provide for net settlement of all outstanding contracts with a counterparty in the case of an event of default or a termination event.

Collateral is generally not required of the counterparties or us under the master netting agreements. As of June 30, 2020 and December 31, 2019, no cash collateral was received or pledged under the master netting agreements.

The effect of net settlement provisions of the master netting agreements on our derivative balances upon an event of default or a termination event was as follows:



(Millions of dollars)	June 30, 2020			December 31, 2019
Derivative Assets
Gross Amount of Recognized Assets	$	187		$	84
Gross Amounts Offset	—			—
Net Amount of Assets⁽¹⁾	187			84
Gross Amounts Not Offset	(33		)	(21		)
Net Amount	$	154		$	63

Derivative Liabilities
Gross Amount of Recognized Liabilities	$	(41	)	$	(50	)
Gross Amounts Offset	—			—
Net Amount of Liabilities⁽¹⁾	(41		)	(50		)
Gross Amounts Not Offset	33			21
Net Amount	$	(8	)	$	(29	)

⁽¹⁾ As presented in the Consolidated Statements of Financial Position.