DERIVATIVE FINANCIAL INSTRUMENTS

Our operations in foreign countries expose us to market risk associated with foreign currency exchange rate fluctuations between the U.S. dollar and various foreign currencies, primarily the Euro. In order to manage this risk, we may hedge a portion of our foreign currency exposures related to outstanding monetary assets and liabilities as well as forecasted product sales using foreign currency exchange forward or option contracts. In general, the market risk related to these contracts is offset by corresponding gains and losses on the hedged transactions. The credit risk associated with these contracts is driven by changes in interest and currency exchange rates and, as a result, varies over time. By working only with major banks and closely monitoring current market conditions, we seek to limit the risk that counterparties to these contracts may be unable to perform. We also seek to limit our risk of loss by entering into contracts that permit net settlement at maturity. Therefore, our overall risk of loss in the event of a counterparty default is limited to the amount of any unrecognized gains on outstanding contracts (i.e., those contracts that have a positive fair value) at the date of default. We do not enter into derivative contracts for trading purposes.

We hedge our exposure to foreign currency exchange rate fluctuations for certain monetary assets and liabilities of our entities that are denominated in a non-functional currency. The derivative instruments we use to hedge this exposure are not designated as hedges, and as a result, changes in their fair value are recorded in Other income (expense), net, on our Consolidated Statements of Income.

We hedge our exposure to foreign currency exchange rate fluctuations for forecasted product sales that are denominated in a non-functional currency. The derivative instruments we use to hedge this exposure are designated as cash flow hedges and have maturities of 18 months or less. Upon executing a hedging contract and quarterly thereafter, we assess hedge effectiveness using regression analysis. Prior to January 2018, we excluded time value from our effectiveness testing and recognized changes in the time value of the hedge in Other income (expense), net, on our Consolidated Statements of Income. Starting in January 2018, we include time value in our effectiveness testing and the entire change in the value of hedge contracts is recorded as unrealized gains or losses in AOCI within Stockholders’ equity on our Consolidated Balance Sheets. The unrealized gains or losses in AOCI are reclassified into product sales when the respective hedged transactions affect earnings. The majority of gains and losses related to the hedged forecasted transactions reported in AOCI at December 31, 2018 are expected to be reclassified to product sales within 12 months.

The cash flow effects of our derivative contracts for the years ended December 31, 2018, 2017 and 2016 are included within Net cash provided by operating activities on our Consolidated Statements of Cash Flows.

We had notional amounts on foreign currency exchange contracts outstanding of $2.2 billion and $2.8 billion at December 31, 2018 and 2017, respectively.

While all of our derivative contracts allow us the right to offset assets and liabilities, we have presented amounts on a gross basis. The following table summarizes the classification and fair values of derivative instruments in our Consolidated Balance Sheets (in millions):



	December 31, 2018
	Asset Derivatives			Liability Derivatives
	Classification	Fair Value		Classification	Fair Value
Derivatives designated as hedges:
Foreign currency exchange contracts	Other current assets	$	73	Other accrued liabilities	$	(1	)
Foreign currency exchange contracts	Other long-term assets	5		Other long-term obligations	—
Total derivatives designated as hedges		78			(1		)
Derivatives not designated as hedges:
Foreign currency exchange contracts	Other current assets	—		Other accrued liabilities	—
Total derivatives not designated as hedges		—			—
Total derivatives		$	78		$	(1	)



	December 31, 2017
	Asset Derivatives			Liability Derivatives
	Classification	Fair Value		Classification	Fair Value
Derivatives designated as hedges:
Foreign currency exchange contracts	Other current assets	$	2	Other accrued liabilities	$	(89	)
Foreign currency exchange contracts	Other long-term assets	1		Other long-term obligations	(3		)
Total derivatives designated as hedges		3			(92		)
Derivatives not designated as hedges:
Foreign currency exchange contracts	Other current assets	10		Other accrued liabilities	(1		)
Total derivatives not designated as hedges		10			(1		)
Total derivatives		$	13		$	(93	)

The following table summarizes the effect of our foreign currency exchange contracts on our Consolidated Financial Statements (in millions):



	Year Ended December 31,
	2018			2017			2016
Derivatives designated as hedges:
Gains (losses) recognized in AOCI	$	114		$	(315	)	$	5
Gains (losses) reclassified from AOCI into product sales	$	(87	)	$	(28	)	$	73
Gains (losses) recognized in Other income (expense), net	$	—		$	41		$	(32	)
Derivatives not designated as hedges:
Gains (losses) recognized in Other income (expense), net	$	(2	)	$	(113	)	$	206

From time to time, we may discontinue cash flow hedges, and as a result, record related amounts in Other income (expense), net, on our Consolidated Statements of Income. There were no material amounts recorded in Other income (expense), net, on our Consolidated Statements of Income for the years presented as a result of the discontinuance of cash flow hedges.

As of December 31, 2018 and 2017, we only held foreign currency exchange contracts. The following table summarizes the potential effect of offsetting derivatives by type of financial instrument on our Consolidated Balance Sheets (in millions):



As of December 31, 2018
Offsetting of Derivative Assets/Liabilities
									Gross Amounts Not Offset on the Consolidated Balance Sheets
Description	Gross Amounts of Recognized Assets/Liabilities			Gross Amounts Offset on the Consolidated Balance Sheets		Amounts of Assets/Liabilities Presented on the Consolidated Balance Sheets			Derivative Financial Instruments			Cash Collateral Received/Pledged		Net Amount (Legal Offset)
Derivative assets	$	78		$	—	$	78		$	(1	)	$	—	$	77
Derivative liabilities	(1		)	—		(1		)	1			—		—

As of December 31, 2017
Offsetting of Derivative Assets/Liabilities
									Gross Amounts Not Offset on the Consolidated Balance Sheets
Description	Gross Amounts of Recognized Assets/Liabilities			Gross Amounts Offset on the Consolidated Balance Sheets		Amounts of Assets/Liabilities Presented on the Consolidated Balance Sheets			Derivative Financial Instruments			Cash Collateral Received/Pledged		Net Amount (Legal Offset)
Derivative assets	$	13		$	—	$	13		$	(8	)	$	—	$	5
Derivative liabilities	(93		)	—		(93		)	8			—		(85		)