HEDGES AND DERIVATIVE FINANCIAL INSTRUMENTS

Derivative instruments are accounted for at fair value based on market rates. Derivatives where we elect hedge accounting are designated as either cash flow or fair value hedges. Derivatives that are not accounted for based on hedge accounting are marked to market through earnings. The accounting for changes in the fair value of a derivative depends on the intended use and designation of the derivative instrument. Hedging ineffectiveness and a net earnings impact occur when the change in the fair value of the hedge does not offset the change in the fair value of the hedged item. The ineffective portion of the gain or loss is recognized in earnings.

Using derivative instruments means assuming counterparty credit risk. Counterparty credit risk relates to the loss we could incur if a counterparty were to default on a derivative contract. We generally deal with investment grade counterparties and monitor the overall credit risk and exposure to individual counterparties. We do not anticipate nonperformance by any counterparties. The amount of counterparty credit exposure is limited to the unrealized gains, if any, on such derivative contracts. We do not require nor do we post collateral or security on such contracts.

Hedging Strategy

In the normal course of business, we manage risks relating to our ongoing business operations including those arising from changes in foreign exchange rates, interest rates and commodity prices. Fluctuations in these rates and prices can affect our operating results and financial condition. We use a variety of strategies, including the use of derivative instruments, to manage these risks. We do not enter into derivative financial instruments for trading or speculative purposes.

Foreign Currency Exchange Rate Risk

We incur expenses associated with the procurement and production of products in a limited number of countries, while we sell in the local currencies of a large number of countries. Our primary foreign currency exchange exposures result from cross-currency sales of products. As a result, we enter into foreign exchange contracts to hedge certain firm commitments and forecasted transactions to acquire products and services that are denominated in foreign currencies.

We enter into certain undesignated non-functional currency asset and liability hedges that relate primarily to short-term payables, receivables and intercompany loans. These forecasted cross-currency cash flows relate primarily to foreign currency denominated expenditures and intercompany financing agreements, royalty agreements and dividends. When we hedge a foreign currency denominated payable or receivable with a derivative, the effect of changes in the foreign exchange rates are reflected currently in interest and sundry (income) expense for both the payable/receivable and the derivative. Therefore, as a result of the economic hedge, we do not elect hedge accounting.

Commodity Price Risk

We enter into commodity derivative contracts on various commodities to manage the price risk associated with forecasted purchases of materials used in our manufacturing process. The objective of these hedges is to reduce the variability of cash flows associated with the forecasted purchase of commodities.

Interest Rate Risk

We may enter into interest rate swap agreements to manage interest rate risk exposure. Our interest rate swap agreements, if any, effectively modify our exposure to interest rate risk, primarily through converting certain of our floating rate debt to a fixed rate basis, and certain fixed rate debt to a floating rate basis. These agreements involve either the receipt or payment of floating rate amounts in exchange for fixed rate interest payments or receipts, respectively, over the life of the agreements without an exchange of the underlying principal amounts. We also may utilize a cross-currency interest rate swap agreement to manage our exposure relating to certain intercompany debt denominated in one foreign currency that will be repaid in another foreign currency. At December 31, 2017 and 2016 there were no outstanding swap agreements.

We may enter into treasury rate lock agreements to effectively modify our exposure to interest rate risk by locking-in interest rates on probable long-term debt issuances.

Net Investment Hedging

The following table summarizes our foreign currency denominated debt and foreign exchange forwards/options designated as net investment hedges at December 31, 2017 and 2016:



	Notional (local)				Notional (USD)				Maturity
Instrument	2017		2016		2017		2016
Senior note - 0.625%	€	500	€	500	$	600	$	527	March 2020
Commercial Paper	€	150	€	—	$	180	$	—	January 2018
Foreign exchange forwards/options	MXN 7,200		MXN 0		$	366	$	—	August 2022

For instruments that are designated and qualify as a net investment hedge, the effective portion of the instruments' gain or loss is reported as a component of OCI and recorded in accumulated other comprehensive loss. The gain or loss will be subsequently reclassified into net earnings when the hedged net investment is either sold or substantially liquidated. The remaining change in fair value of the hedge instruments represents the ineffective portion, which is immediately recognized in interest and sundry (income) expense on our consolidated statements of income. As of December 31, 2017, there was no ineffectiveness on hedges designated as net investment hedges.

The following tables summarize our outstanding derivative contracts and their effects on our Consolidated Balance Sheets at December 31, 2017 and 2016:



					Fair Value of								Type of Hedge ⁽¹⁾
	Notional Amount				Hedge Assets				Hedge Liabilities					Maximum Term (Months)
Millions of dollars	2017		2016		2017		2016		2017		2016			2017	2016
Derivatives accounted for as hedges
Foreign exchange forwards/options	$	3,113	$	1,813	$	55	$	32	$	157	$	10	(CF/NI)	56	58
Commodity swaps/options	269		299		29		7		1		11		(CF)	36	36
Total derivatives accounted for as hedges					$	84	$	39	$	158	$	21
Derivatives not accounted for as hedges
Foreign exchange forwards/options	$	3,390	$	3,262	$	58	$	39	$	50	$	16	N/A	33	35
Commodity swaps/options	1		2		—		—		—		—		N/A	5	2
Total derivatives not accounted for as hedges					58		39		50		16
Total derivatives					$	142	$	78	$	208	$	37

Current					$	89	$	54	$	81	$	35
Noncurrent					53		24		127		2
Total derivatives					$	142	$	78	$	208	$	37

⁽¹⁾ Derivatives accounted for as hedges are considered either cash flow (CF) or net investment (NI) hedges in 2017. During 2016, foreign exchange derivatives accounted for as hedges were classified as cash flow hedges.

The effects of derivative instruments on our Consolidated Statements of Income and Comprehensive Income for OCI for the years ended December 31, 2017 and 2016 are as follows:



	Gain (Loss) Recognized in OCI (Effective Portion)					Gain (Loss) Reclassified from OCI into Income (Effective Portion) ⁽¹⁾
Cash Flow Hedges - Millions of dollars	2017			2016		2017			2016
Foreign exchange forwards/options	$	(164	)	$	27	$	(122	)	$	66		(a)
Commodity swaps/options	59			53		43			(30		)	(a)
Interest rate derivatives	—			—		(1		)	(1		)	(b)
Net Investment Hedges
Foreign currency	(49		)	28		—			—
	$	(154	)	$	108	$	(80	)	$	35



	Gain (Loss) Recognized on Derivatives not Accounted for as Hedges ⁽²⁾
Derivatives not Accounted for as Hedges - Millions of dollars	2017			2016
Foreign exchange forwards/options	$	(40	)	$	26


⁽¹⁾	Gains and losses reclassified from accumulated OCI and recognized in income are recorded in (a) cost of products sold, (b) interest expense or (c) other (income) expense.

⁽²⁾Mark to market gains and losses recognized in income are recorded in interest and sundry income (expense).

For cash flow hedges, the amount of ineffectiveness recognized in interest and sundry income (expense) was nominal during 2017 and 2016. There were no hedges designated as fair value in 2017 and 2016. The net amount of unrealized gain or loss on derivative instruments included in accumulated OCI related to contracts maturing and expected to be realized during the next twelve months is a loss of $58 million at December 31, 2017.