NOTE 8. DERIVATIVES AND HEDGING ACTIVITIES

Universal is exposed to various risks in its worldwide operations and uses derivative financial instruments to manage two specific types of risks – interest rate risk and foreign currency exchange rate risk. Interest rate risk has been managed by entering into interest rate swap agreements, and foreign currency exchange rate risk has been managed by entering into forward foreign currency exchange contracts, primarily in the Brazilian real, the euro, the Polish zloty, and the Hungarian forint. The Company's policy also permits other types of derivative instruments. In addition, foreign currency exchange rate risk is also managed through strategies that do not involve derivative instruments, such as using local borrowings and other approaches to minimize net monetary positions in non-functional currencies. The disclosures below provide additional information about the Company's hedging strategies, the derivative instruments used, and the effects of these activities on the consolidated statements of income and the consolidated balance sheets. In the consolidated statements of cash flows, the cash flows associated with all of these activities are reported in cash flows from operating activities, except for the proceeds received on the early termination of interest rate swap agreements, which are reported in cash flows from financing activities. The Company has not hedged any net investment in the equity of subsidiaries denominated in currencies other than the U.S. dollar.

Hedging Strategy for Interest Rate Risk

The Company has outstanding debt in both fixed and floating rate instruments and is exposed to market risk due to changes in interest rates. The Company's management weighs many factors in determining how to manage its interest rate risk, including its interest rate exposure on committed inventories, its financing options, and general market conditions.

The Company entered into receive-fixed/pay-floating interest rate swap agreements that were designated and qualified as hedges of the exposure to changes in the fair value of the underlying debt instruments created by fluctuations in prevailing market interest rates. At December 31, 2010 and March 31, 2011, the Company had receive-fixed/pay-floating interest rate swaps outstanding in the total notional amount of $245 million. During the quarter ended September 30, 2011, several of those swap contracts in the notional amount of $50 million were settled on maturity of the underlying debt, and the remaining contracts in the total notional amount of $195 million were settled prior to maturity at an aggregate gain of approximately $13 million. That gain is being amortized over the remaining terms of the underlying debt instruments as a reduction in interest expense. No fixed-to-floating interest rate swap agreements were outstanding at December 31, 2011.

In November 2011, the Company entered into receive-floating/pay-fixed interest rate swap agreements that were designated and qualify as hedges of the exposure to changes in interest payment cash flows created by fluctuations in variable interest rates on outstanding debt. Although no significant ineffectiveness is expected with this hedging strategy, the effectiveness of the interest rate swaps is evaluated on a quarterly basis. The receive-floating/pay-fixed interest rate swap agreements are effective March 31, 2012, and relate to $99 million notional amount of outstanding debt. The aggregate notional amount of the interest rate swaps will be reduced over a five-year period as payments are made on the underlying debt. At December 31, 2011, the notional amount of floating-to-fixed interest rate swaps outstanding was $99 million.

Cash Flow Hedging Strategy for Foreign Currency Exchange Rate Risk Related to Forecast Purchases of Tobacco and Related Processing Costs

The majority of the tobacco production in most countries outside the United States where Universal operates is sold in export markets at prices denominated in U.S. dollars. However, purchases of tobacco from farmers and most processing costs (such as labor and energy) in those countries are usually denominated in the local currency. Changes in exchange rates between the U.S. dollar and the local currencies where tobacco is grown and processed affect the ultimate U.S. dollar cost of the processed tobacco. From time to time, the Company has entered into forward contracts to sell U.S. dollars and buy the local currency at future dates that coincide with the expected timing of tobacco purchases and processing costs. This strategy offsets the variability of future U.S. dollar cash flows for those purchases and costs for the foreign currency notional amount hedged. To date, this hedging strategy has been used mainly for tobacco purchases and processing costs in Brazil.

For the crops bought, processed, and sold in fiscal years 2011 and 2012, all contracts related to tobacco purchases in Brazil were designated and qualify as hedges of the future cash flows associated with the forecast purchases of tobacco. As a result, except for insignificant amounts related to any ineffective portion of the hedging strategy, changes in fair values of the forward contracts have been recognized in comprehensive income as they occurred, but only recognized in earnings upon sale of the related tobacco to third-party customers. Forward contracts related to processing costs have not been designated as hedges, and gains and losses on those contracts have been recognized in earnings on a mark-to-market basis.

In fiscal year 2012, the Company hedged approximately $188 million U.S. dollar notional amount related to tobacco purchases in Brazil. Additional forward contracts totaling approximately $55 million U.S. dollar notional amount were entered to mitigate currency exposure on processing costs related to those crops. For substantially all hedge gains and losses recorded in accumulated other comprehensive loss at December 31, 2011, the Company expects to complete the sale of the tobacco and recognize the amounts in earnings in fiscal year 2012.

In fiscal year 2011, the Company hedged approximately $109 million U.S. dollar notional amount related to tobacco purchases in Brazil, and additional forward contracts totaling approximately $58 million U.S. dollar notional amount were entered to mitigate currency exposure on processing costs related to that crop. All hedge gains and losses recorded in accumulated other comprehensive loss were recognized in cost of goods sold with the sale of the tobacco during fiscal year 2011.

Hedging Strategy for Foreign Currency Exchange Rate Risk Related to Net Local Currency Monetary Assets and Liabilities of Foreign Subsidiaries

Most of the Company's foreign subsidiaries transact the majority of their sales in U.S. dollars and finance the majority of their operating requirements with U.S. dollar borrowings, and therefore use the U.S. dollar as their functional currency. These subsidiaries normally have certain monetary assets and liabilities on their balance sheets that are denominated in the local currency. Net monetary assets and liabilities denominated in the local currency are remeasured into U.S. dollars each reporting period, generating gains and losses that the Company records in earnings as a component of selling, general and administrative expenses. The risk exposure related to local currency net monetary positions fluctuates throughout the year, based on the operating cycle. Local currency net monetary positions generate remeasurement gains or losses when local currency exchange rates fluctuate compared to the U.S. dollar. To manage a portion of its exposure to currency remeasurement gains and losses, from time to time, the Company enters into forward contracts to buy or sell local currency at future dates coinciding with the expected changes in the overall net local currency monetary positions. Gains and losses on these forward contracts are recorded in earnings as a component of selling, general, and administrative expenses for each reporting period as they occur, and thus directly offset the related remeasurement losses or gains in the consolidated statements of income for the notional amount hedged. The Company does not designate these contracts as hedges for accounting purposes. The notional amount of these contracts totaled approximately $60 million in fiscal year 2011. No contracts have been entered for this purpose in fiscal year 2012. To further mitigate currency remeasurement exposure, some of the Company's foreign subsidiaries have obtained short-term local currency financing during certain periods. This strategy, while not involving the use of derivative instruments, is intended to minimize the subsidiary's net monetary position by financing a portion of the local currency monetary assets with local currency monetary liabilities and thus hedging a portion of the overall position.

Several of the Company's foreign subsidiaries transact the majority of their sales and finance the majority of their operating requirements in their local currency, and therefore use their respective local currencies as the functional currency for reporting purposes. From time to time, these subsidiaries sell tobacco to customers in transactions that are not denominated in the functional currency. In those situations, the subsidiaries routinely enter into forward exchange contracts to offset currency risk for the period of time that a fixed-price order and the related trade account receivable are outstanding with the customer. The contracts are not designated as hedges for accounting purposes.

Effect of Derivative Financial Instruments on the Consolidated Statements of Income

The table below outlines the effects of the Company's use of derivative financial instruments on the consolidated statements of income for the three and nine months ended December 31, 2011 and 2010.


	Three Months Ended December 31,						Nine Months Ended December 31,
(in thousands of dollars)	2011			2010			2011			2010

Fair Value Hedges - Interest Rate Swap Agreements
Derivative
Gain (loss) recognized in earnings	$	—		$	(3,980	)	$	3,195		$	2,721
Location of gain (loss) recognized in earnings	Interest expense

Hedged Item
Description of hedged item	Fixed rate long-term debt
Gain (loss) recognized in earnings	$	—		$	3,980		$	(3,195	)	$	(2,721	)
Location of gain (loss) recognized in earnings	Interest expense

Cash Flow Hedges - Interest Rate Swap Agreements
Derivative
Effective Portion of Hedge
Gain (loss) recorded in accumulated other comprehensive loss	$	(820	)	$	—		$	(820	)	$	—
Gain (loss) reclassified from accumulated other comprehensive loss into earnings	$	—		$	—		$	—		$	—
Location of gain (loss) reclassified from accumulated other comprehensive loss into earnings	Interest expense

Ineffective Portion of Hedge
Gain (loss) recognized in earnings	$	—		$	—		$	—		$	—
Location of gain (loss) recognized in earnings	Selling, general and administrative expenses

Hedged Item
Description of hedged item	Floating rate interest payments on term loan

Cash Flow Hedges - Forward Foreign Currency Exchange Contracts
Derivative
Effective Portion of Hedge
Gain (loss) recorded in accumulated other comprehensive loss	$	99		$	—		$	3,430		$	—
Gain (loss) reclassified from accumulated other comprehensive loss into earnings	$	1,520		$	—		$	5,343		$	100
Location of gain (loss) reclassified from accumulated other comprehensive loss into earnings	Cost of goods sold

Ineffective Portion and Early De-designation of Hedges
Gain (loss) recognized in earnings	$	—		$	—		$	858		$	101
Location of gain (loss) recognized in earnings	Selling, general and administrative expenses

Hedged Item
Description of hedged item	Forecast purchases of tobacco in Brazil

Derivatives Not Designated as Hedges -
Forward Foreign Currency Exchange Contracts
Contracts related to forecast processing costs and forecast purchases of tobacco,primarily in Brazil
Gain (loss) recognized in earnings	$	316		$	(64	)	$	1,614		$	1,138
Location of gain (loss) recognized in earnings	Selling, general and administrative expenses

Contracts related to net local currency monetary assets and liabilities of subsidiary in Brazil
Gain (loss) recognized in earnings	$	—		$	—		$	—		$	661
Location of gain (loss) recognized in earnings	Selling, general and administrative expenses

Contracts related to fixed-price orders and accounts receivable of non-U.S. dollar subsidiaries
Gain (loss) recognized in earnings	$	(383	)	$	(511	)	$	(591	)	$	(169	)
Location of gain (loss) recognized in earnings	Selling, general and administrative expenses

Total gain (loss) recognized in earnings for forward foreign currency exchange contracts not designated as hedges	$	(67	)	$	(575	)	$	1,023		$	1,630

For the interest rate swap agreements designated as fair value hedges, since the hedges had no ineffectiveness, the gain or loss recognized in earnings on the derivative was offset by a corresponding loss or gain on the underlying hedged debt. For the interest rate swap agreements designated as cash flow hedges, the effective portion of the gain or loss on the derivative is recorded in accumulated other comprehensive loss and any ineffective portion is recorded in selling, general and administrative expenses.

For the forward foreign currency exchange contracts designated as cash flow hedges of tobacco purchases in Brazil, a net hedge gain of approximately $0.5 million remained in accumulated other comprehensive loss at December 31, 2011. That balance reflects net gains on open and settled contracts primarily related to the 2010-2011 crop, less the amount reclassified to earnings related to tobacco sold through December 31, 2011. The majority of the balance in accumulated other comprehensive loss will be recognized in earnings as a component of cost of goods sold during fiscal year 2012 as the remaining 2010-2011 Brazilian crop tobacco is sold to customers. Based on the hedging strategy, as the gain or loss is recognized in earnings, it is expected to be offset by a change in the direct cost for the tobacco or by a change in sales prices if the strategy has been mandated by the customer. Generally, margins on the sale of the tobacco will not be significantly affected.

Effect of Derivative Financial Instruments on the Consolidated Balance Sheets

The table below outlines the effects of the Company's derivative financial instruments on the consolidated balance sheets at December 31, 2011 and 2010, and March 31, 2011:


	Derivatives in a Fair Value Asset Position							Derivatives in a Fair Value Liability Position
	Balance	Fair Value as of						Balance	Fair Value as of
	Sheet	Dec. 31,		Dec. 31,		March 31,		Sheet	Dec. 31,		Dec. 31,		March 31,
(in thousands of dollars)	Location	2011		2010		2011		Location	2011		2010		2011
Derivatives Designated as Hedging Instruments
Interest rate swap	Other
agreements	non-							Long-term
designated	current							obligations
as fair value hedges	assets	$	—	$	12,486	$	10,193		$	—	$	—	$	—

Interest rate swap	Other
agreements	non-							Other
designated	current							long-term
as cash flow hedges	assets		—		—		—	liabilities		820		—		—

Forward foreign								Accounts
currency exchange	Other							payable and
contracts	current							accrued
	assets		—		—		2,400	expenses		63		—		—
Total		$	—	$	12,486	$	12,593		$	883	$	—	$	—

Derivatives Not Designated as Hedging Instruments
Forward foreign								Accounts
currency exchange	Other							payable and
contracts	current							accrued
	assets	$	15	$	172	$	1,222	expenses	$	474	$	272	$	243
Total		$	15	$	172	$	1,222		$	474	$	272	$	243