8. DERIVATIVES AND HEDGING TRANSACTIONS

The company uses foreign currency forward contracts, interest rate swap agreements and foreign currency debt to manage risks associated with foreign currency exchange rates, interest rates and net investments in foreign operations. The company does not hold derivative financial instruments of a speculative nature or for trading purposes. The company records derivatives as assets and liabilities on the balance sheet at fair value. Changes in fair value are recognized immediately in earnings unless the derivative qualifies and is designated as a hedge. Cash flows from derivatives are classified in the statement of cash flows in the same category as the cash flows from the items subject to designated hedge or undesignated (economic) hedge relationships. The company evaluates hedge effectiveness at inception and on an ongoing basis. If a derivative is no longer expected to be effective, hedge accounting is discontinued. Hedge ineffectiveness, if any, is recorded in earnings.

The company is exposed to credit risk in the event of nonperformance of counterparties for foreign currency forward exchange contracts and interest rate swap agreements. The company monitors its exposure to credit risk by using credit approvals and credit limits and by selecting major international banks and financial institutions as counterparties. The company does not anticipate nonperformance by any of these counterparties, and therefore, recording a valuation allowance against the company’s derivative balance is not considered necessary.

Derivative Positions Summary

Certain of the company’s derivative transactions are subject to master netting arrangements that allow the company to net settle contracts with the same counterparties. These arrangements generally do not call for collateral and as of the applicable dates presented in the following table no cash collateral had been received or pledged related to the underlying derivatives.

The respective net amounts are included in other current assets, other non-current assets and other current liabilities on the Consolidated Balance Sheet.

The following table summarizes the gross fair value and the net value of the company’s outstanding derivatives.



	Asset Derivatives				Liability Derivatives
(millions)	September 30		December 31		September 30		December 31
	2016		2015		2016		2015
Derivatives designated as hedging instruments
Foreign currency forward contracts		$ 33.7		$ 70.2		$ 32.6		$ 3.2
Interest rate swap agreements		5.1		-		12.7		5.4

Derivatives not designated as hedging instruments
Foreign currency forward contracts		13.0		41.0		19.9		32.7
Gross value of derivatives		51.8		111.2		65.2		41.3

Gross amounts offset in the Consolidated Balance Sheet		(20.9)		(9.8)		(20.9)		(9.8)
Net value of derivatives		$ 30.9		$ 101.4		$ 44.3		$ 31.5

The following table summarizes the notional values of the company’s outstanding derivatives.


	Notional Values
	September 30		December 31
(millions)	2016		2015

Foreign currency forward contracts		$ 4,285		$ 4,029
Interest rate agreements		$ 2,075		$ 1,675
Net investment hedge contracts (a)		€ 65		€ 25

(a)

The net investment hedge contracts exclude the company’s euro denominated debt.

Cash Flow Hedges

The company utilizes foreign currency forward contracts to hedge the effect of foreign currency exchange rate fluctuations on forecasted foreign currency transactions, including inventory purchases and intercompany royalty, management fee and other payments. These forward contracts are designated as cash flow hedges. The effective portions of the changes in fair value of these contracts are recorded in accumulated other comprehensive income (“AOCI”) until the hedged items affect earnings, at which time the gain or loss is reclassified into the same line item in the Consolidated Statement of Income as the underlying exposure being hedged. All cash flow hedged transactions are forecasted to occur within the next two years.

The company occasionally enters into treasury lock and forward starting interest rate swap agreements to manage interest rate exposure.

During 2016 and 2015, the company entered into treasury lock and forward starting interest rate swap agreements, respectively. The agreements were closed in October 2016, subsequent to the end of the third quarter, in conjunction with the debt issuance discussed in Note 5. Certain other forward starting interest rate swap agreements opened in 2015 were closed in January 2016, in conjunction with the debt issuance discussed in Note 5.

During 2014, the company entered into a series of forward starting interest rate swap agreements, which were subsequently closed, in connection with both its U.S. public debt issuance completed in January 2015 and its euro public debt issuance completed in July 2015. During 2011, the company entered into and subsequently closed a series of forward starting interest rate swap agreements in connection with the issuance of its private placement debt. During 2006, the company entered into and subsequently closed two forward starting interest rate swap agreements related to the issuance of its senior euro notes.

The agreements noted above were designated and effective as a cash flow hedge of the expected interest payments related to the anticipated future debt issuance. Amounts recorded in AOCI for the respective transactions above are recognized as part of interest expense over the remaining life of the notes as the forecasted interest transactions occur.

The effective portion of gains and losses recognized into AOCI and earnings from derivative contracts that qualified as cash flow hedges was as follows:



		Third Quarter Ended				Nine Months Ended
		September 30				September 30
(millions)		2016		2015		2016		2015
Unrealized gain (loss) recognized into AOCI
Foreign currency forward contracts	AOCI (equity)		$ (12.9)		$ 19.0		$ (40.4)		$ 38.9
Interest rate swap agreements	AOCI (equity)		1.4		7.7		(11.5)		1.2
	Total		$ (11.5)		$ 26.7		$ (51.9)		$ 40.1

		Third Quarter Ended				Nine Months Ended
(millions)		September 30				September 30
Gain (loss) recognized in income		2016		2015		2016		2015
Foreign currency forward contracts	Cost of sales		$ 5.0		$ 13.3		$ 26.6		$ 23.2
	SG&A		(0.7)		0.2		(20.3)		1.1
	Interest expense, net		-		1.4		2.9		1.4
	Subtotal		4.3		14.9		9.2		25.7

Interest rate swap agreements	Interest expense, net		(1.6)		(1.4)		(4.8)		(4.0)
	Total		$ 2.7		$ 13.5		$ 4.4		$ 21.7

Gains and losses recognized in income related to the ineffective portion of the company’s cash flow hedges were insignificant during the first nine months of 2016 and 2015.

Fair Value Hedges

The company manages interest expense using a mix of fixed and floating rate debt. To help manage exposure to interest rate movements and to reduce borrowing costs, the company may enter into interest rate swaps under which the company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed upon notional principal amount. The mark-to-market of these fair value hedges is recorded as gains or losses in interest expense and is offset by the gain or loss of the underlying debt instrument, which is also recorded in interest expense. These fair value hedges are highly effective and thus, there is no impact on earnings due to hedge ineffectiveness.

In January 2016, the company entered into an interest rate swap agreement that converted its $400 million 2.00% debt from a fixed rate to a floating rate. In January 2015, the company entered into interest rate swap agreements that converted its $300 million 1.55% debt, its $250 million 3.69% debt and a portion of its $1.25 billion 3.00% debt from fixed rates to floating interest rates. In May 2014, the company entered into an interest rate swap agreement that converted its $500 million 1.45% debt from a fixed rate to a floating interest rate.

The interest rate swaps referenced above were designated as fair value hedges.

The impact on earnings from derivative contracts that qualified as fair value hedges was as follows:



		Third Quarter Ended				Nine Months Ended
		September 30				September 30
(millions)		2016		2015		2016		2015

Gain (loss) on derivative recognized income
Interest rate swap	Interest expense, net		$ (7.6)		$ 7.6		$ 6.1		$ 9.5

Gain (loss) on hedged item recognized income
Interest rate swap	Interest expense, net		$ 7.6		$ (7.6)		$ (6.1)		$ (9.5)

Net Investment Hedges

The company designates its outstanding €175 million and €575 million (total of $837 million as of September 30, 2016) senior notes (“euronotes”) and related accrued interest as a hedge of existing foreign currency exposures related to net investments the company has in certain euro denominated functional currency subsidiaries.

In addition to the euro denominated debt designated as net investment hedges, the company also occasionally enters into forward contracts to hedge an additional portion of its net investment in euro denominated functional currency subsidiaries. As noted in the table on page 17, the total notional value of which is €65 million as of September 30, 2016.

The revaluation gains and losses on the euronotes and of the forward contracts, which are designated and effective as hedges of the company’s net investments, have been included as a component of the cumulative translation adjustment account and were as follows:


	Third Quarter Ended				Nine Months Ended
	September 30				September 30
(millions)	2016		2015		2016		2015
Revaluation gains (losses), net of tax		$ (1.2)		$ (12.0)		$ (29.1)		$ 66.8

Derivatives Not Designated as Hedging Instruments

The company also uses foreign currency forward contracts to offset its exposure to the change in value of certain foreign currency denominated assets and liabilities held at foreign subsidiaries, primarily receivables and payables, which are remeasured at the end of each period. Although the contracts are effective economic hedges, they are not designated as accounting hedges. Therefore, changes in the value of these derivatives are recognized immediately in earnings, thereby offsetting the current earnings effect of the related foreign currency denominated assets and liabilities.

The impact on earnings from derivative contracts that are not designated as hedging instruments was as follows:


		Third Quarter Ended				Nine Months Ended
		September 30				September 30
(millions)		2016		2015		2016		2015
Gain (loss) recognized in income
Foreign currency forward contracts	SG&A		$ (12.0)		$ 7.1		$ (27.3)		$ 6.4
	Interest expense, net		1.0		(0.3)		(2.1)		(10.9)
	Total		$ (11.0)		$ 6.8		$ (29.4)		$ (4.5)

The amounts recognized in SG&A above offset the earnings impact of the related foreign currency denominated assets and liabilities. The amounts recognized in interest expense above represent the component of the hedging gains (losses) attributable to the difference between the spot and forward rates of the hedges as a result of interest rate differentials.