10. Derivative Instruments and Hedging Activities

We are exposed to certain market risks relating to our ongoing business operations, including foreign currency exchange rate risk, commodity price risk, interest rate risk and credit risk. We manage our exposure to these and other market risks through regular operating and financing activities. Currently, the only risks that we manage through the use of derivative instruments are interest rate risk and foreign currency exchange rate risk.

Interest Rate Risk

Derivatives Designated as Fair Value Hedges

In prior years, we entered into various fixed-to-variable interest rate swap agreements that were accounted for as fair value hedges of a portion of the Senior Notes due 2019 and all the Senior Notes due 2021. In August 2016, we received cash for these interest rate swap assets by terminating the hedging instruments with the counterparties. The remaining unamortized balance as of March 31, 2017 was $29.3 million.

Derivatives Designated as Cash Flow Hedges

In 2014, we entered into forward starting interest rate swaps that were designated as cash flow hedges of the thirty-year tranche of senior notes (the 4.450% Senior Notes due 2045) we expected to issue in 2015. The forward starting interest rate swaps mitigated the risk of changes in interest rates prior to the completion of the offering of senior notes in connection with the Biomet merger. The interest rate swaps were settled, and the remaining loss to be recognized at March 31, 2017 was $28.1 million.

In September 2016, we entered into various variable-to-fixed interest rate swap agreements with a notional amount of $375 million that were accounted for as cash flow hedges of Term Loan B. The interest rate swaps minimize the exposure to changes in the LIBOR interest rates while the variable-rate debt is outstanding. The weighted average fixed interest rate for all of the swaps executed is approximately 0.82 percent through September 30, 2019.

Foreign Currency Exchange Rate Risk

We operate on a global basis and are exposed to the risk that our financial condition, results of operations and cash flows could be adversely affected by changes in foreign currency exchange rates. To reduce the potential effects of foreign currency exchange rate movements on net earnings, we enter into derivative financial instruments in the form of foreign currency exchange forward contracts with major financial institutions. We also designated our Euro Notes and other foreign currency exchange forward contracts as net investment hedges of investments in foreign subsidiaries. We are primarily exposed to foreign currency exchange rate risk with respect to transactions and net assets denominated in Euros, Swiss Francs, Japanese Yen, British Pounds, Canadian Dollars, Australian Dollars, Korean Won, Swedish Krona, Czech Koruna, Thai Baht, Taiwan Dollars, South African Rand, Russian Rubles, Indian Rupees, Turkish Lira, Polish Zloty, Danish Krone, and Norwegian Krone. We do not use derivative financial instruments for trading or speculative purposes.

Derivatives Designated as Net Investment Hedges

We are exposed to the impact of foreign exchange rate fluctuations in the investments in our wholly-owned foreign subsidiaries that are denominated in currencies other than the U.S. Dollar. In order to mitigate the volatility in foreign exchange rates, we issued Euro Notes in December 2016 and designated 100 percent of the Euro Notes to hedge our net investment in certain wholly-owned foreign subsidiaries that have a functional currency of Euro. All changes in the fair value of the hedging instrument designated as a net investment hedge are recorded as a component of accumulated other comprehensive loss in the consolidated balance sheet.

In the three months ended March 31, 2017, we recognized a foreign exchange loss of $14.8 million in AOCI on our net investment hedges. We recognized no ineffectiveness from our net investment hedges for the three months ended March 31, 2017.

Derivatives Designated as Cash Flow Hedges

Our revenues are generated in various currencies throughout the world. However, a significant amount of our inventory is produced in U.S. Dollars. Therefore, movements in foreign currency exchange rates may have different proportional effects on our revenues compared to our cost of products sold. To minimize the effects of foreign currency exchange rate movements on cash flows, we hedge intercompany sales of inventory expected to occur within the next 30 months with foreign currency exchange forward contracts. We designate these derivative instruments as cash flow hedges.

We perform quarterly assessments of hedge effectiveness by verifying and documenting the critical terms of the hedge instrument and confirming that forecasted transactions have not changed significantly. We also assess on a quarterly basis whether there have been adverse developments regarding the risk of a counterparty default. For derivatives which qualify as hedges of future cash flows, the effective portion of changes in fair value is temporarily recorded in other comprehensive income and then recognized in cost of products sold when the hedged item affects net earnings. The ineffective portion of a derivative’s change in fair value, if any, is immediately reported in cost of products sold. On our condensed consolidated statement of cash flows, the settlements of these cash flow hedges are recognized in operating cash flows.

For foreign currency exchange forward contracts and options outstanding at March 31, 2017, we had obligations to purchase U.S. Dollars and sell Euros, Japanese Yen, British Pounds, Canadian Dollars, Australian Dollars, Korean Won, Swedish Krona, Czech Koruna, Thai Baht, Taiwan Dollars, South African Rand, Russian Rubles, Indian Rupees, Turkish Lira, Polish Zloty, Danish Krone, and Norwegian Krone and obligations to purchase Swiss Francs and sell U.S. Dollars. These derivatives mature at dates ranging from April 2017 through September 2019. As of March 31, 2017, the notional amounts of outstanding forward contracts and options entered into with third parties to purchase U.S. Dollars were $1,599.5 million. As of March 31, 2017, the notional amounts of outstanding forward contracts and options entered into with third parties to purchase Swiss Francs were $309.9 million.

Derivatives Not Designated as Hedging Instruments

We enter into foreign currency forward exchange contracts with terms of one month to manage currency exposures for monetary assets and liabilities denominated in a currency other than an entity’s functional currency. As a result, any foreign currency re-measurement gains/losses recognized in earnings are generally offset with gains/losses on the foreign currency forward exchange contracts in the same reporting period. The net amount of these offsetting gains/losses is recorded in other expense. These contracts are settled on the last day of each reporting period. Therefore, there is no outstanding balance related to these contracts recorded on the balance sheet as of the end of the reporting period. The notional amounts of these contracts are typically in a range of $1.75 billion to $2.25 billion per quarter.

Income Statement Presentation

Derivatives Designated as Fair Value Hedges

Derivative instruments designated as fair value hedges had the following effects on our condensed consolidated statements of earnings (in millions):

Gain (Loss) on Instrument

Gain (Loss) on Hedged Item

Three Months Ended

Location on
Statement of Earnings

March 31,

Derivative Instrument

2017

2016

2017

2016

Interest rate swaps

Interest expense

—

10.8

—

(10.8

)

Derivatives Designated as Cash Flow Hedges

Derivative instruments designated as cash flow hedges had the following effects, before taxes, on AOCI and net earnings on our condensed consolidated statements of earnings, condensed consolidated statements of comprehensive income and condensed consolidated balance sheets (in millions):


	Amount of Gain (Loss) Recognized in AOCI								Amount of Gain (Loss) Reclassified from AOCI
	Three Months Ended March 31,						Location on Statement of Earnings		Three Months Ended March 31,
Derivative Instrument	2017			2016			Location on Statement of Earnings		2017			2016
Foreign exchange forward contracts	$	(37.2	)	$	(56.5	)		Cost of products sold	$	11.1		$	32.1
Interest rate swaps		0.6			—			Interest expense		—			—
Forward starting interest rate swaps		—			—			Interest expense		(0.1	)		(0.4	)

	$	(36.6	)	$	(56.5	)			$	11.0		$	31.7

The net amounts recognized in earnings during the three month periods ended March 31, 2017 and 2016 due to ineffectiveness and amounts excluded from the assessment of hedge effectiveness were not significant.

The fair value of outstanding derivative instruments designated as cash flow hedges and recorded on the balance sheet at March 31, 2017, together with settled derivatives where the hedged item has not yet affected earnings, was a net unrealized loss of $11.4 million, or $3.0 million after taxes, which is deferred in AOCI. A gain of $12.6 million, or $11.4 million after taxes, is expected to be reclassified to earnings in cost of products sold and a loss of $0.5 million, or $0.3 million after taxes, is expected to be reclassified to earnings in interest expense over the next twelve months.

Derivatives Not Designated as Hedging Instruments

The following losses from these derivative instruments were recognized on our condensed consolidated statements of earnings (in millions):


	Location on Statement of Earnings	Three Months Ended March 31,
Derivative Instrument	Location on Statement of Earnings	2017			2016
Foreign exchange forward contracts	Other expense, net	$	(27.8	)	$	(21.3	)

These losses do not reflect offsetting gains of $25.6 million and $18.3 million in the three month periods ended March 31, 2017 and 2016, respectively, recognized in other expense, net as a result of foreign currency re-measurement of monetary assets and liabilities denominated in a currency other than an entity’s functional currency.

Balance Sheet Presentation

As of March 31, 2017 and December 31, 2016, all derivative instruments designated as fair value hedges and cash flow hedges were recorded at fair value on the balance sheet. On our condensed consolidated balance sheets, we recognize individual forward contracts and options with the same counterparty on a net asset/liability basis if we have a master netting agreement with the counterparty. Under these master netting agreements, we are able to settle derivative instrument assets and liabilities with the same counterparty in a single transaction, instead of settling each derivative instrument separately. We have master netting agreements with all of our counterparties. The fair value of derivative instruments on a gross basis is as follows (in millions):


	March 31, 2017				December 31, 2016
	Balance Sheet Location		Fair Value		Balance Sheet Location		Fair Value
*Asset Derivatives*
Foreign exchange forward contracts		Other current assets	$	39.3		Other current assets	$	57.9
Foreign exchange forward contracts		Other assets		17.0		Other assets		34.9
Interest rate swaps		Other assets		4.6		Other assets		4.0

Total asset derivatives			$	60.9			$	96.8


*Liability Derivatives*
Foreign exchange forward contracts		Other current liabilities	$	27.3		Other current liabilities	$	20.9
Foreign exchange forward contracts		Other long-term liabilities		9.9		Other long-term liabilities		6.9

Total liability derivatives			$	37.2			$	27.8

The table below presents the effects of our master netting agreements on our condensed consolidated balance sheets (in millions):


		As of March 31, 2017						As of December 31, 2016
Description	Location	Gross Amount		Offset		Net Amount in Balance Sheet		Gross Amount		Offset		Net Amount in Balance Sheet
*Asset Derivatives*
Cash flow hedges	Other current assets		$39.3		20.2		$19.1		$57.9		$20.6		$37.3
Cash flow hedges	Other assets		17.0		8.2		8.8		34.9		6.8		28.1

*Liability Derivatives*
Cash flow hedges	Other current liabilities		27.3		20.2		7.1		20.9		20.6		0.3
Cash flow hedges	Other long-term liabilities		9.9		8.2		1.7		6.9		6.8		0.1

The following net investment hedge losses were recognized on our condensed consolidated statements of comprehensive income (in millions):


	Amount of Loss Recognized in OCI
	Three Months Ended March 31,
Derivative Instrument	2017			2016
Euro Notes	$	(14.8	)	$	—