Derivatives and hedging
Exchange rate and interest rate risks are managed with a variety of straightforward techniques, including match funding and selective use of derivatives. We use derivatives to mitigate or eliminate certain financial and market risks because we conduct business in diverse markets around the world and local funding is not always efficient. In addition, we use derivatives to adjust the debt we are issuing to match the fixed or floating nature of the assets we are acquiring. We apply strict policies to manage each of these risks, including prohibitions on derivatives trading, derivatives market-making or other speculative activities.
To qualify for hedge accounting, the details of the hedging relationship must be formally documented at inception of the arrangement, including the risk management objective, hedging strategy, hedged item, specific risks that are being hedged, the derivative instrument and how effectiveness is being assessed. The derivative must be highly effective in offsetting either changes in fair value or cash flows, as appropriate, for the risk being hedged. Effectiveness is evaluated on a retrospective and prospective basis. If a hedge relationship becomes ineffective, it no longer qualifies as a hedge. Any excess gains or losses attributable to such ineffectiveness, as well as subsequent changes in the fair value of the derivative, are recognized in earnings.
Cash flow hedges
Cash flow hedges are hedges that use simple derivatives to offset the variability of expected future cash flows. Variability can appear in floating rate assets, floating rate liabilities or from certain types of forecasted transactions, and can arise from changes in interest rates or currency exchange rates. For example, GECS often borrows at a variable rate of interest to fund our financial services businesses. If Commercial Finance needs the funds to make a floating rate loan, there is no exposure to interest rate changes, and no hedge is necessary. However, upon making a fixed rate loan, we will contractually commit to pay a fixed rate of interest to a counterparty who will pay us a variable rate of interest (an “interest rate swap”). We then designate this swap as a cash flow hedge of the associated variable-rate borrowing. If, as expected, the derivative is perfectly effective in offsetting variable interest in the borrowing, we record changes in its fair value in a separate component in equity, then release those changes to earnings contemporaneously with the earnings effects of the hedged item. Further information about hedge effectiveness is provided on page 115.
We use currency forwards and options to manage exposures to changes in currency exchange rates associated with commercial purchase and sale transactions. These instruments permit us to eliminate the cash flow variability, in local currency, of costs or selling prices denominated in currencies other than the functional currency. In addition, we use these instruments, along with interest rate and currency swaps, to convert borrowings into the currency of the local market in which we do business.
At December 31, 2004, amounts related to derivatives qualifying as cash flow hedges amounted to a reduction of equity of $1,223 million, of which we expect to transfer $427 million to earnings in 2005 along with the earnings effects of the related forecasted transactions. At December 31, 2004, the amount of unrecognized losses related to cash flow hedges of short-term borrowings was $1,823 million. In 2004, there were no forecasted transactions that failed to occur. At December 31, 2004, the maximum term of derivative instruments that hedge forecasted transactions was 23 years and related to hedges of anticipated bond purchases in the Insurance business.
Fair value hedges
Fair value hedges are hedges that eliminate the risk of changes in the fair values of assets, liabilities and certain types of firm commitments. For example, we will use an interest rate swap in which we receive a fixed rate of interest and pay a variable rate of interest to change the cash flow profile of a fixed-rate borrowing to match the variable rate financial asset that it is funding. We record changes in fair value of derivatives designated and effective as fair value hedges in earnings, offset by corresponding changes in the fair value of the hedged item.
We use interest rate swaps, currency swaps and interest rate and currency forwards to hedge the effects of interest rate and currency exchange rate changes on local and nonfunctional currency denominated fixed-rate borrowings and certain types of fixed rate assets. Fair value adjustments increased the carrying amount of debt outstanding at December 31, 2004, by $1,739 million. We use equity options to hedge price changes in investment securities.
Net investment hedges
Net investment hedges are hedges that use derivative contracts or cash instruments to hedge the foreign currency exposure of a net investment in a foreign operation. We manage currency exposures that result from net investments in affiliates principally by funding assets denominated in local currency with debt denominated in that same currency. In certain circumstances, we manage such exposures with currency forwards and currency swaps.
Derivatives not designated as hedges
We must meet specific criteria in order to apply any of the three forms of hedge accounting. For example, hedge accounting is not permitted for hedged items that are marked to market through earnings. We use derivatives to hedge exposures when it makes economic sense to do so, including circumstances in which the hedging relationship does not qualify for hedge accounting as described in the following paragraph. We also will occasionally receive derivatives, such as equity warrants, in the ordinary course of business. Derivatives that do not qualify for hedge accounting are marked to market through earnings.
We use swaps and option contracts, including caps, floors and collars, as an economic hedge of changes in interest rates, currency exchange rates and equity prices on certain types of assets and liabilities. We occasionally obtain equity warrants as part of sourcing or financing transactions. Although these instruments are considered to be derivatives, their economic risk is similar to, and managed on the same basis as, other equity instruments we hold.
Earnings effects of derivatives
The table that follows provides additional information about the earnings effects of derivatives. In the context of hedging relationships, “effectiveness” refers to the degree to which fair value changes in the hedging instrument offset the corresponding expected earnings effects of the hedged item. Certain elements of hedge positions cannot qualify for hedge accounting under SFAS 133 whether effective or not, and must therefore be marked to market through earnings. Time value of purchased options is the most common example of such elements in instruments we use. Pre-tax earnings effects of such items are shown in the following table as “Amounts excluded from the measure of effectiveness.”
| December 31 (In millions) | 2004 | 2003 | ||||
|---|---|---|---|---|---|---|
| CASH FLOW HEDGES | ||||||
| Ineffectiveness | $ | 2 | $ | (19 | ) | |
| Amounts excluded from the measure of effectiveness | 25 | — | ||||
| FAIR VALUE HEDGES | ||||||
| Ineffectiveness | 11 | — | ||||
| Amounts excluded from the measure of effectiveness | 3 | — | ||||
In 2004, Energy recognized a loss of $30 million, after tax and before cancelation penalties, for terminating a forward euro contract when our customer canceled its hedged, firm order for equipment and services.
Counterparty credit risk
The risk that counterparties to derivative contracts will default and not make payments to us according to the terms of the agreements is counterparty credit risk. We manage counterparty credit risk on an individual counterparty basis, which means that we net exposures on transactions by counterparty where legal right of offset exists to determine the amount of exposure to each counterparty. When a counterparty exceeds credit exposure limits (see table below), as measured by current market value of the derivative contract, no additional transactions are permitted to be executed until the exposure with that counterparty is reduced to an amount that is within the established limits.
Swaps are required to be executed under master agreements containing mutual credit downgrade provisions that provide the ability to require assignment or termination in the event either party is downgraded below A3 or A-.
To further mitigate credit risk, in certain cases we have entered into collateral arrangements that provide us with the right to hold collateral when the current market value of derivative contracts exceeds an exposure threshold. Under these arrangements, we may receive U.S. Treasury and other highly-rated securities or cash to secure our exposure to counterparties; such collateral is available to us in the event that a counterparty defaults. From an economic standpoint, we evaluate credit risk exposures and compliance with credit exposure limits net of such collateral. If the downgrade provisions had been triggered at December 31, 2004, we could have been required to disburse up to $5.4 billion and could have claimed $4.7 billion from counterparties, including $3.0 billion of collateral that has been pledged to us.
Fair values of our derivative assets and liabilities represent the replacement value of existing derivatives at market prices and can change significantly from period to period based on, among other factors, market movements and changes in our positions. At December 31, 2004 and 2003, gross fair value gains amounted to $6.5 billion and $5.5 billion, respectively. At December 31, 2004 and 2003, gross fair value losses amounted to $7.2 billion and $6.9 billion, respectively.
The following tables illustrate our policy relating to exposure limits to counterparties.
| Credit Rating | ||||
| Moody’s | S&P | |||
| Foreign exchange forwards and other derivatives less than one year | P-1 | A-1 | ||
| All derivatives between one and five years | Aa3 | (a) | AA- | (a) |
| All derivatives greater than five years | Aaa | (a) | AAA | (a) |
| (a) | Counterparties that have an obligation to provide collateral to cover credit exposure in accordance with a credit support agreement must have a minimum A3/A- rating. |
| Exposure | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| Greater than one year | |||||||||
| (In millions) | Less than one year | With collateral | Without collateral | ||||||
| Minimum rating | |||||||||
| Aaa/AAA | $ | 150 | $ | 100 | $ | 75 | |||
| Aa3/AA- | 150 | 50 | 50 | ||||||
| A3/A- | 150 | 5 | Not allowed | ||||||
| 2004 | 2003 | |||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Assets (liabilities) | Assets (liabilities) | |||||||||||||||||
| December 31 (In millions) | Notional amount | Carrying amount (net) | Estimated fair value | Notional amount | Carrying amount (net) | Estimated fair value | ||||||||||||
| GE | ||||||||||||||||||
| Assets | ||||||||||||||||||
| Investments and notes receivable | $ | (a) | $ | 3,465 | $ | 3,545 | $ | (a) | $ | 645 | $ | 645 | ||||||
| Liabilities | ||||||||||||||||||
| Borrowings(b)(c) | (a) | (11,034 | ) | (11,144 | ) | (a) | (10,943 | ) | (10,991 | ) | ||||||||
| Other financial instruments | (a) | (758 | ) | (855 | ) | (a) | — | — | ||||||||||
| GECS | ||||||||||||||||||
| Assets | ||||||||||||||||||
| Time sales and loans(f) | (a) | 216,035 | 217,155 | (a) | 183,624 | 183,169 | ||||||||||||
| Other commercial and residential mortgages | (a) | 11,213 | 11,402 | (a) | 8,759 | 9,085 | ||||||||||||
| Other financial instruments | (a) | 3,206 | 3,420 | (a) | 2,701 | 2,701 | ||||||||||||
| Liabilities | ||||||||||||||||||
| Borrowings(b)(c)(f) | (a) | (360,799 | ) | (370,946 | ) | (a) | (319,941 | ) | (331,227 | ) | ||||||||
| Investment contract benefits | (a) | (35,312 | ) | (35,337 | ) | (a) | (34,224 | ) | (34,035 | ) | ||||||||
| Insurance — financial guarantees and credit life(d) | 223,299 | (3,582 | ) | (3,582 | ) | 171,338 | (3,935 | ) | (3,935 | ) | ||||||||
| Other firm commitments | ||||||||||||||||||
| Ordinary course of business lending commitments | ||||||||||||||||||
| Fixed rate | 2,503 | — | — | 2,158 | — | — | ||||||||||||
| Variable rate | 8,156 | — | — | 8,923 | — | — | ||||||||||||
| Unused revolving credit lines(e) | ||||||||||||||||||
| Commercial | ||||||||||||||||||
| Fixed rate | 1,210 | — | — | 896 | — | — | ||||||||||||
| Variable rate | 21,411 | — | — | 15,953 | — | — | ||||||||||||
| Consumer — principally credit cards | ||||||||||||||||||
| Fixed rate | 141,965 | — | — | 107,892 | — | — | ||||||||||||
| Variable rate | 200,219 | — | — | 131,106 | — | — | ||||||||||||
| (a) | These financial instruments do not have notional amounts. |
| (b) | Included effects of interest rate swaps and cross currency swaps. |
| (c) | See note 18. |
| (d) | See note 19. |
| (e) | Excluded inventory financing arrangements, which may be withdrawn at our option, of $8.9 billion and $4.2 billion as of December 31, 2004 and 2003, respectively. |
| (f) | As restated. |
Assets and liabilities that are reflected in the accompanying financial statements at fair value are not included in the above disclosures; such items include cash and equivalents, investment securities, separate accounts and derivative financial instruments. Other assets and liabilities — those not carried at fair value — are discussed below. Apart from certain of our borrowings and certain marketable securities, few of the instruments discussed below are actively traded and their fair values must often be determined using models. Although we have made every effort to represent accurate estimated fair values in this section, there is no assurance that such estimates could actually have been realized at December 31, 2004 or 2003.
A description of how we estimate fair values follows.
Time sales and loans
Based on quoted market prices, recent transactions and/or discounted future cash flows, using rates at which similar loans would have been made to similar borrowers.
Borrowings
Based on discounted future cash flows using current market rates which are comparable to market quotes.
Investment contract benefits
Based on expected future cash flows, discounted at currently offered discount rates for immediate annuity contracts or cash surrender values for single premium deferred annuities.
All other instruments
Based on comparable market transactions, discounted future cash flows, quoted market prices, and/or estimates of the cost to terminate or otherwise settle obligations.
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