Annual Report - CoBank

Note 11 – Derivative FinancialInstruments and Hedging ActivitiesRisk Management Objectives and StrategiesWe maintain an overall interest rate risk managementstrategy that incorporates the use of derivative financialinstruments to manage liquidity and minimize significantunplanned fluctuations in earnings that are caused by interestrate volatility. Our goal is to manage interest rate sensitivityby modifying the repricing frequency or effective maturity ofcertain balance sheet assets and liabilities. We also maintain aforeign exchange risk management strategy to reduce theimpact of currency fluctuations on our relatively nominalamount of foreign currency-denominated loans. As a result ofinterest rate and foreign exchange rate fluctuations, fixed-rateassets and liabilities will appreciate or depreciate in marketvalue. The effect of this unrealized appreciation ordepreciation is expected to be substantially offset by gains andlosses on the derivative instruments that are linked to theseassets and liabilities. Interest rate and foreign exchangefluctuations also cause interest income and interest expense ofvariable-rate assets and liabilities to increase or decrease. Theeffect of this variability in earnings is expected to besubstantially offset by gains and losses on the derivativeinstruments that are linked to these assets and liabilities.Uses of DerivativesTo achieve risk management objectives and satisfy thefinancing needs of our borrowers, we execute variousderivative transactions with other financial institutions.Derivatives (primarily interest rate swaps) are used to manageliquidity and the interest rate risk arising from maturity andrepricing mismatches between assets and liabilities. Underinterest rate swap arrangements, we agree with a third-party toexchange, at specified intervals, payment streams calculatedon a specified notional amount, with at least one paymentstream based on a specified floating-rate index. We use avariety of interest rate swaps including the exchange offloating-rate for fixed-rate swaps and fixed-rate for floatingrateswaps with payment obligations tied to specific indices. Inaddition, we execute foreign exchange spot and forwardcontracts to manage currency risk on loans denominated inforeign currencies. We also enter into derivatives for ourcustomers as a service to enable them to transfer, modify orreduce their interest rate risk and foreign exchange risk bytransferring such risk to us. We substantially offset this risktransference by concurrently entering into offsettingagreements with counterparties.The notional amounts and related activity of derivatives atDecember 31, 2011, 2010 and 2009 are shown in thefollowing table.Activity in the Notional Amounts of DerivativeFinancial Instruments($ in Millions) Swaps CapsSpots andForwardsTotalDecember 31, 2010 $ 28,699 $ 2,056 $ 199 $ 30,954Additions /Accretion 6,226 - 5,271 11,497Maturities /Amortization (8,937) (38) (5,171) (14,146)Terminations (2,733) (19) - (2,752)December 31, 2011 $ 23,255 $ 1,999 $ 299 $ 25,553December 31, 2009 $ 30,748 $ 1,600 $ 218 $ 32,566Additions /Accretion 4,700 528 2,699 7,927Maturities /Amortization (6,489) (72) (2,718) (9,279)Terminations (260) - - (260)December 31, 2010 $ 28,699 $ 2,056 $ 199 $ 30,954December 31, 2008 $ 26,452 $ 1,911 $ 354 $ 28,717Additions /Accretion 10,129 3 3,432 13,564Maturities /Amortization (5,434) (314) (3,568) (9,316)Terminations (399) - - (399)December 31, 2009 $ 30,748 $ 1,600 $ 218 $ 32,566Accounting for Derivative Instruments and HedgingActivitiesWe record derivatives as assets or liabilities at their fairvalue on the consolidated balance sheets. We record changesin the fair value of a derivative in current period earnings oraccumulated other comprehensive income (loss), dependingon the use of the derivative and whether it qualifies for hedgeaccounting. For fair value hedge transactions that hedgechanges in the fair value of assets or liabilities, changes in thefair value of the derivative will generally be offset in theincome statement by changes in the hedged item’s fair valueattributable to the risk being hedged. For cash flow hedgetransactions, in which we hedge the variability of future cashflows related to a variable-rate asset or liability, changes in thefair value of the derivative are reported in accumulated othercomprehensive income (loss). The gains and losses on thederivatives that we report in accumulated other comprehensiveincome (loss) will be reclassified as earnings in the periods inwhich earnings are affected by the variability of the cash flowsof the hedged item. We record the ineffective portion of allhedges in current period earnings.For our customer transactions, which are not designatedas hedging instruments, we record the related changes in fairvalue in current period earnings. We substantially offset thisrisk transference by concurrently entering into offsettingagreements with counterparties, with the changes in fair valueof these transactions also recorded in current period earnings.CoBank 2011 Annual Report94