Derivative Financial Instruments

6 Months Ended

Jul. 01, 2011

Derivative Financial Instruments

Derivative Financial Instruments

6. Derivative Financial Instruments

Financial Contracts and Market Risk

We conduct business on a global basis in U.S. and foreign currencies subjecting us to risks associated with fluctuating foreign exchange rates. To mitigate these risks, we use derivative foreign exchange contracts to address nonfunctional exposures that are expected to be settled in one year or less. The derivative foreign exchange contracts consist of foreign currency forward and option contracts.

Derivative financial contracts involve elements of market and credit risk. The market risk that results from these contracts relates to changes in foreign currency exchange rates, which generally are offset by changes in the value of the underlying assets or liabilities being held. Credit risk relates to the risk of nonperformance by a counterparty to one of the derivative contracts. We do not believe there is a significant credit risk associated with our hedging activities. We monitor the counterparties' credit ratings and other market data to minimize credit risk. In addition, we also limit the aggregate contract amount entered into with any one financial institution to mitigate credit risk.

Cash Flow Hedges

At July 1, 2011, we did not have any cash flow hedges outstanding. We use foreign currency forward and option contracts, designated as cash flow hedges, to mitigate currency risk related to an imbalance of nonfunctional currency denominated costs and related revenue. We conduct monthly effectiveness tests of these hedging relationships on a spot-to-spot basis, excluding forward points. Effective gains and losses from derivative contracts are recorded in Accumulated other comprehensive income until the underlying transactions occur, at which time they are reclassified to Total cost of revenue. Ineffectiveness is recorded to Other (expense) income, net. If it becomes probable that an anticipated transaction that is hedged will not occur, we immediately reclassify the gains or losses related to that hedge from Accumulated other comprehensive income to Other (expense) income, net. We continue to monitor the Company's overall currency exposure and may elect to add additional cash flow hedges in the future if deemed necessary.

Balance Sheet Hedges (Non-designated Hedges)

Short-term monetary assets and liabilities denominated in currencies other than the functional currency of the Tellabs entity entering into the transaction are remeasured through income as foreign currency rates fluctuate. Changes in the value of derivative contracts intended to offset these fluctuations are also recorded in income. These derivative contracts are not designated as hedges. At July 1, 2011, we held non-designated foreign currency forward contracts in 11 currencies, with a gross notional equivalent of $159.0 million.

Net Investment Hedges

We entered into three-month foreign currency forward contracts, designated as net investment hedges, to hedge a portion of our net investment in one of our foreign subsidiaries to preserve the U.S. dollar value of our Euro cash. Effective changes in the fair value of these contracts due to exchange rate fluctuations are recorded within Accumulated other comprehensive income. Those amounts will be reflected in income only when we dispose of the investment in the foreign subsidiary. We conduct monthly effectiveness tests of net investment hedges on a spot-to-spot basis, excluding forward points, and any measurement of ineffectiveness is recorded in income. As of July 1, 2011, we had a net unrealized gain of $6.7 million in Accumulated other comprehensive income related to settled contracts. We held net investment hedges with a notional value of 50 million Euros at the end of the quarter.

The fair value of derivative instruments in the Consolidated Balance Sheet as of July 1, 2011, was as follows:

	Asset Derivatives Reported in Miscellaneous Receivables and Other Current Assets		Liability Derivatives Reported in Other Accrued Liabilities
Net investment hedges	$	—	$	—
Balance sheet hedges (Non-designated hedges)		0.2		0.2
Total derivatives	$	0.2	$	0.2

The fair value of derivative instruments in the Consolidated Balance Sheet as of December 31, 2010, was as follows:

	Asset Derivatives Reported in Miscellaneous Receivables and Other Current Assets		Liability Derivatives Reported in Other Accrued Liabilities
Cash flow and net investment hedges	$	—	$	0.8
Balance sheet hedges (Non-designated hedges)		0.2		0.2
Total derivatives	$	0.2	$	1.0

The effect of derivative instruments designated as hedging instruments on the Consolidated Statements of Operations follows:

	Three Months Ended
	Gain (Loss) Recognized  in Accumulated OCI, net (Effective Portion)					Gain Reclassified  from Accumulated OCI into Total Cost of Revenue (Effective Portion)				Loss Recognized in Other Income net: Excluded from Effectiveness  Testing Gain (Loss)
	7/1/11			7/2/10		7/1/11		7/2/10		7/1/11			7/2/10
Cash flow hedges	$	—		$	0.9	$	—	$	1.0	$	—		$	—
Net investment hedges	$	(2.7	)	$	5.9		N/A		N/A	$	(0.2	)	$	—

	Six Months Ended
	Gain (Loss) Recognized  in Accumulated OCI, net (Effective Portion)					Gain Reclassified from Accumulated OCI into Total Cost  of Revenue (Effective Portion)				Loss Recognized in Other Income, net: Excluded  from Effectiveness Testing Gain (Loss)
	7/1/11			7/2/10		7/1/11		7/2/10		7/1/11			7/2/10
Cash flow hedges	$	—		$	1.8	$	—	$	0.6	$	—		$	—
Net investment hedges	$	(10.0	)	$	10.6		N/A		N/A	$	(0.3	)	$	—

The effect of derivative instruments not designated as hedging instruments on the Consolidated Statements of Operations follows:

	Second Quarter					Six Months
	Gain (Loss) Recognized in Other (Expense) Income, net 1					Gain (Loss) Recognized in Other Income), net 1
	7/1/11		7/2/10			7/1/11		7/2/10
Foreign currency forward and option contracts	$	2.1	$	(8.1	)	$	6.5	$	(13.5	)

¹ The gains or losses from changes in the fair value of the derivative contracts are generally offset by gains or losses of the underlying transactions being hedged.