Financial Instruments:

Overview

PMI operates in markets outside of the United States of America, with manufacturing and sales facilities in various locations around the world. PMI utilizes certain financial instruments to manage foreign currency exposure. Derivative financial instruments are used by PMI principally to reduce exposures to market risks resulting from fluctuations in foreign currency exchange rates by creating offsetting exposures. PMI is not a party to leveraged derivatives and, by policy, does not use derivative financial instruments for speculative purposes. Financial instruments qualifying for hedge accounting must maintain a specified level of effectiveness between the hedging instrument and the item being hedged, both at inception and throughout the hedged period. PMI formally documents the nature and relationships between the hedging instruments and hedged items, as well as its risk-management objectives, strategies for undertaking the various hedge transactions and method of assessing hedge effectiveness. Additionally, for hedges of forecasted transactions, the significant characteristics and expected terms of the forecasted transaction must be specifically identified, and it must be probable that each forecasted transaction will occur. If it were deemed probable that the forecasted transaction would not occur, the gain or loss would be recognized in earnings. PMI reports its net transaction gains or losses in marketing, administration and research costs on the condensed consolidated statements of earnings.

PMI uses deliverable and non-deliverable forward foreign exchange contracts, foreign currency swaps, foreign currency collars and foreign currency options, collectively referred to as foreign exchange contracts, to mitigate its exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. The primary currencies to which PMI is exposed include the Euro, Indonesian rupiah, Japanese yen, Mexican peso, Russian ruble, Swiss franc and Turkish lira. At September 30, 2012, PMI had contracts with aggregate notional amounts of $13.4 billion. Of the $13.4 billion aggregate notional amount at September 30, 2012, $3.9 billion related to cash flow hedges, $0.9 billion related to hedges of net investments in foreign operations and $8.6 billion related to other derivatives that primarily offset currency exposures on intercompany financing.

The fair value of PMI’s foreign exchange contracts included in the condensed consolidated balance sheet as of September 30, 2012 and December 31, 2011, were as follows:



	Asset Derivatives					Liability Derivatives
		Fair Value					Fair Value
(in millions)	Balance Sheet Classification	At September 30, 2012		At December 31, 2011		Balance Sheet Classification	At September 30, 2012		At December 31, 2011
Foreign exchange contracts designated as hedging instruments	Other current assets	$	38	$	57	Other accrued liabilities	$	4	$	4
	Other assets	15		—		Other liabilities	3		—
Foreign exchange contracts not designated as hedging instruments	Other current assets	19		88		Other accrued liabilities	55		62
						Other liabilities	1		—
Total derivatives		$	72	$	145		$	63	$	66

Hedging activities, which represent movement in derivatives as well as the respective underlying transactions, had the following effect on PMI’s condensed consolidated statements of earnings and other comprehensive earnings for the nine months and three months ended September 30, 2012 and 2011:



(in millions)	For the Nine Months Ended September 30, 2012
Gain (Loss)	Cash Flow Hedges			Net Investment Hedges			Other Derivatives		Income Taxes		Total
Statement of Earnings:
Net revenues	$	33					$	—			$	33
Cost of sales	19						—				19
Marketing, administration and research costs	—						—				—
Operating income	52						—				52
Interest expense, net	(43		)				11				(32		)
Earnings before income taxes	9						11				20
Provision for income taxes	(1		)				1				—
Net earnings attributable to PMI	$	8					$	12			$	20
Other Comprehensive Earnings:
Gains transferred to earnings	$	(9	)						$	1	$	(8	)
Recognized losses	(20		)						3		(17		)
Net impact on equity	$	(29	)						$	4	$	(25	)
Cumulative translation adjustment				$	(11	)			$	4	$	(7	)



(in millions)	For the Nine Months Ended September 30, 2011
Gain (Loss)	Cash Flow Hedges			Net Investment Hedges		Other Derivatives			Income Taxes			Total
Statement of Earnings:
Net revenues	$	(9	)			$	—					$	(9	)
Cost of sales	5					—						5
Marketing, administration and research costs	—					—						—
Operating income	(4		)			—						(4		)
Interest expense, net	(26		)			37						11
Earnings before income taxes	(30		)			37						7
Provision for income taxes	3					(9		)				(6		)
Net earnings attributable to PMI	$	(27	)			$	28					$	1
Other Comprehensive Earnings:
Losses transferred to earnings	$	30							$	(3	)	$	27
Recognized losses	(22		)						2			(20		)
Net impact on equity	$	8							$	(1	)	$	7
Cumulative translation adjustment				$	2							$	2



(in millions)	For the Three Months Ended September 30, 2012
Gain (Loss)	Cash Flow Hedges			Net Investment Hedges			Other Derivatives		Income Taxes		Total
Statement of Earnings:
Net revenues	$	9					$	—			$	9
Cost of sales	—						—				—
Marketing, administration and research costs	—						—				—
Operating income	9						—				9
Interest expense, net	(13		)				5				(8		)
Earnings before income taxes	(4		)				5				1
Provision for income taxes	—						1				1
Net earnings attributable to PMI	$	(4	)				$	6			$	2
Other Comprehensive Earnings:
Losses transferred to earnings	$	4							$	—	$	4
Recognized losses	(33		)						4		(29		)
Net impact on equity	$	(29	)						$	4	$	(25	)
Cumulative translation adjustment				$	(11	)			$	4	$	(7	)



(in millions)	For the Three Months Ended September 30, 2011
Gain (Loss)	Cash Flow Hedges			Net Investment Hedges		Other Derivatives			Income Taxes			Total
Statement of Earnings:
Net revenues	$	(9	)			$	—					$	(9	)
Cost of sales	5					—						5
Marketing, administration and research costs	—					—						—
Operating income	(4		)			—						(4		)
Interest expense, net	(10		)			23						13
Earnings before income taxes	(14		)			23						9
Provision for income taxes	1					(5		)				(4		)
Net earnings attributable to PMI	$	(13	)			$	18					$	5
Other Comprehensive Earnings:
Losses transferred to earnings	$	14							$	(1	)	$	13
Recognized losses	(27		)						2			(25		)
Net impact on equity	$	(13	)						$	1		$	(12	)
Cumulative translation adjustment				$	—							$	—

Each type of hedging activity is described in greater detail below.

Cash Flow Hedges

PMI has entered into foreign exchange contracts to hedge foreign currency exchange risk related to certain forecasted transactions. The effective portion of gains and losses associated with qualifying cash flow hedge contracts is deferred as a component of accumulated other comprehensive losses until the underlying hedged transactions are reported in PMI’s condensed consolidated statements of earnings. During the nine months and three months ended September 30, 2012 and 2011, ineffectiveness related to cash flow hedges was not material. As of September 30, 2012, PMI has hedged forecasted transactions for periods not exceeding the next fifteen months. The impact of these hedges is included in operating cash flows on PMI’s condensed consolidated statements of cash flows.

For the nine months and three months ended September 30, 2012 and 2011, foreign exchange contracts that were designated as cash flow hedging instruments impacted the condensed consolidated statements of earnings and other comprehensive earnings as follows:



(pre-tax, in millions)	For the Nine Months Ended September 30,
Derivatives in Cash Flow Hedging Relationship	Statement of Earnings Classification of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings	Amount of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings						Amount of Gain/(Loss) Recognized in Other Comprehensive Earnings on Derivatives
		2012			2011			2012			2011
Foreign exchange contracts								$	(20	)	$	(22	)
	Net revenues	$	33		$	(9	)
	Cost of sales	19			5
	Marketing, administration and research costs	—			—
	Interest expense, net	(43		)	(26		)
Total		$	9		$	(30	)	$	(20	)	$	(22	)



(pre-tax, in millions)	For the Three Months Ended September 30,
Derivatives in Cash Flow Hedging Relationship	Statement of Earnings Classification of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings	Amount of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings						Amount of Gain/(Loss) Recognized in Other Comprehensive Earnings on Derivatives
		2012			2011			2012			2011
Foreign exchange contracts								$	(33	)	$	(27	)
	Net revenues	$	9		$	(9	)
	Cost of sales	—			5
	Marketing, administration and research costs	—			—
	Interest expense, net	(13		)	(10		)
Total		$	(4	)	$	(14	)	$	(33	)	$	(27	)

Hedges of Net Investments in Foreign Operations

PMI designates certain foreign currency denominated debt and foreign exchange contracts as net investment hedges of its foreign operations. For the nine months ended September 30, 2012 and 2011, these hedges of net investments resulted in gains (losses), net of income taxes, of $(30) million and $(137) million, respectively. For the three months ended September 30, 2012 and 2011, these hedges of net investments resulted in gains (losses), net of income taxes, of $(70) million and $139 million, respectively. These gains (losses) were reported as a component of accumulated other comprehensive losses within currency translation adjustments. For the nine months and three months ended September 30, 2012 and 2011, ineffectiveness related to net investment hedges was not material. Other investing cash flows on PMI’s condensed consolidated statements of cash flows includes the premiums paid for and settlements of net investment hedges.

For the nine months and three months ended September 30, 2012 and 2011, foreign exchange contracts that were designated as net investment hedging instruments impacted the condensed consolidated statements of earnings and other comprehensive earnings as follows:



(pre-tax, in millions)	For the Nine Months Ended September 30,
Derivatives in Net Investment Hedging Relationship	Statement of Earnings Classification of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings	Amount of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings				Amount of Gain/(Loss) Recognized in Other Comprehensive Earnings on Derivatives
		2012		2011		2012			2011
Foreign exchange contracts						$	(11	)	$	2
	Interest expense, net	$	—	$	—



(pre-tax, in millions)	For the Three Months Ended September 30,
Derivatives in Net Investment Hedging Relationship	Statement of Earnings Classification of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings	Amount of Gain/(Loss) Reclassified from Other Comprehensive Earnings into Earnings				Amount of Gain/(Loss) Recognized in Other Comprehensive Earnings on Derivatives
		2012		2011		2012			2011
Foreign exchange contracts						$	(11	)	$	—
	Interest expense, net	$	—	$	—

Other Derivatives

PMI has entered into foreign exchange contracts to hedge the foreign currency exchange risks related to intercompany loans between certain subsidiaries, and third-party loans. While effective as economic hedges, no hedge accounting is applied for these contracts; therefore, the unrealized gains (losses) relating to these contracts are reported in PMI’s condensed consolidated statements of earnings. For the nine months ended September 30, 2012 and 2011, the gains (losses) from contracts for which PMI did not apply hedge accounting were $66 million and $144 million, respectively. For the three months ended September 30, 2012 and 2011, the gains (losses) from contracts for which PMI did not apply hedge accounting were $190 million and $6 million, respectively. The gains (losses) from these contracts substantially offset the losses and gains generated by the underlying intercompany and third-party loans being hedged.

As a result, for the nine months and three months ended September 30, 2012 and 2011, these items impacted the condensed consolidated statements of earnings as follows:



(pre-tax, in millions)
Derivatives not Designated as Hedging Instruments	Statement of Earnings Classification of Gain/(Loss)	Amount of Gain/(Loss) Recognized in Earnings
		For the Nine Months Ended September 30,				For the Three Months Ended September 30,
		2012		2011		2012		2011
Foreign exchange contracts
	Marketing, administration and research costs	$	—	$	—	$	—	$	—
	Interest expense, net	11		37		5		23
		$	11	$	37	$	5	$	23

Qualifying Hedging Activities Reported in Accumulated Other Comprehensive Losses

Derivative gains or losses reported in accumulated other comprehensive losses are a result of qualifying hedging activity. Transfers of these gains or losses to earnings are offset by the corresponding gains or losses on the underlying hedged item. Hedging activity impacted accumulated other comprehensive losses, net of income taxes, as follows:



(in millions)	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2012			2011			2012			2011
Gain at beginning of period	$	15		$	2		$	15		$	21
Derivative (gains)/losses transferred to earnings	(8		)	27			4			13
Change in fair value	(17		)	(20		)	(29		)	(25		)
(Loss)/gain as of September 30	$	(10	)	$	9		$	(10	)	$	9

At September 30, 2012, PMI expects $11 million of derivative losses that are included in accumulated other comprehensive losses to be reclassified to the condensed consolidated statement of earnings within the next twelve months. These losses are expected to be substantially offset by the statement of earnings impact of the respective hedged transactions.

Credit Exposure and Credit Risk

PMI is exposed to credit loss in the event of non-performance by counterparties. While PMI does not anticipate non-performance, its risk is limited to the fair value of the financial instruments. PMI actively monitors its exposure to credit risk through the use of credit approvals and credit limits, and by selecting and continuously monitoring a diverse group of major international banks and financial institutions as counterparties.

Contingent Features

PMI’s derivative instruments do not contain contingent features.

Fair Value

See Note 13. Fair Value Measurements for disclosures related to the fair value of PMI’s derivative financial instruments.