Derivative instruments

The Company is exposed to foreign currency exchange rate risks and interest rate risks related to its business operations. To reduce our risks related to these exposures, we utilize or have utilized certain derivative instruments, including foreign currency forward, foreign currency option, cross-currency swap, forward interest rate and interest rate swap contracts. We do not use derivatives for speculative trading purposes.

Cash flow hedges

We are exposed to possible changes in the values of certain anticipated foreign currency cash flows resulting from changes in foreign currency exchange rates associated primarily with our euro-denominated international product sales. Increases and decreases in the cash flows associated with our international product sales due to movements in foreign currency exchange rates are offset partially by corresponding increases and decreases in the cash flows from our international operating expenses resulting from these foreign currency exchange rate movements. To further reduce our exposure to foreign currency exchange rate fluctuations on our international product sales, we enter into foreign currency forward and option contracts to hedge a portion of our projected international product sales, primarily over a three-year time horizon, with, at any given point in time, a higher percentage of nearer-term projected product sales being hedged than in successive periods.

As of September 30, 2016, and December 31, 2015, we had open foreign currency forward contracts with notional amounts of $3.5 billion and $3.3 billion, respectively, and open foreign currency option contracts with notional amounts of $178 million and $225 million, respectively. We have designated these foreign currency forward and foreign currency option contracts, which are primarily euro based, as cash flow hedges; and accordingly, we report the effective portions of the unrealized gains and losses on these contracts in AOCI in the Condensed Consolidated Balance Sheets, and we reclassify them to earnings in the same periods during which the hedged transactions affect earnings.

To hedge our exposure to foreign currency exchange rate risk associated with certain of our long-term debt denominated in foreign currencies, we entered into cross-currency swap contracts. Under the terms of these contracts, we paid euros, pounds sterling and Swiss francs and received U.S. dollars for the notional amounts at the inception of the contracts; and based on these notional amounts, we exchange interest payments at fixed rates over the lives of the contracts by paying U.S. dollars and receiving euros, pounds sterling and Swiss francs. In addition, we will pay U.S. dollars to and receive euros, pounds sterling and Swiss francs from the counterparties at the maturities of the contracts for these same notional amounts. The terms of these contracts correspond to the related hedged debt, effectively converting the interest payments and principal repayment on the debt from euros, pounds sterling and Swiss francs to U.S. dollars. We have designated these cross-currency swap contracts as cash flow hedges, and accordingly, the effective portions of the unrealized gains and losses on these contracts are reported in AOCI in the Condensed Consolidated Balance Sheets and reclassified to earnings in the same periods during which the hedged debt affects earnings.

The notional amounts and interest rates of our cross-currency swaps are as follows (notional amounts in millions):



	Foreign currency				U.S. dollars
Hedged notes	Notional amount		Interest rate		Notional amount		Interest rate
2.125% 2019 euro Notes	€	675	2.125	%	$	864	2.6	%
1.25% 2022 euro Notes	€	1,250	1.25	%	$	1,388	3.2	%
0.41% 2023 Swiss franc Bonds	CHF	700	0.41	%	$	704	3.4	%
2.00% 2026 euro Notes	€	750	2.00	%	$	833	3.9	%
5.50% 2026 pound sterling Notes	£	475	5.50	%	$	747	6.0	%
4.00% 2029 pound sterling Notes	£	700	4.00	%	$	1,111	4.5	%

In connection with anticipated issuances of long-term fixed-rate debt, we entered into forward interest rate contracts during the nine months ended September 30, 2016. The forward interest rate contracts hedged the variability in cash flows due to changes in the applicable Treasury rate between the time we entered into these contracts and the time the related debt was issued in August 2016. Gains and losses realized on such contracts, which were designated as cash flow hedges, were recognized in AOCI and are being amortized into earnings over the lives of the associated debt issuances.

The effective portions of the unrealized gain/(loss) recognized in other comprehensive income for our derivative instruments designated as cash flow hedges were as follows (in millions):



	Three months ended						Nine months ended
	September 30,						September 30,
Derivatives in cash flow hedging relationships	2016			2015			2016			2015
Foreign currency contracts	$	(26	)	$	53		$	(88	)	$	346
Cross-currency swap contracts	67			(118		)	(128		)	(199		)
Forward interest rate contracts	(6		)	—			(10		)	—
Total	$	35		$	(65	)	$	(226	)	$	147

The locations in the Condensed Consolidated Statements of Income and the effective portions of the gain/(loss) reclassified out of AOCI and into earnings for our derivative instruments designated as cash flow hedges were as follows (in millions):



		Three months ended						Nine months ended
		September 30,						September 30,
Derivatives in cash flow hedging relationships	Statements of Income location	2016			2015			2016			2015
Foreign currency contracts	Product sales	$	67		$	86		$	242		$	246
Cross-currency swap contracts	Interest and other income, net	(1		)	(67		)	(143		)	(114		)
Forward interest rate contracts	Interest expense, net	(1		)	—			(1		)	(1		)
Total		$	65		$	19		$	98		$	131

No portions of our cash flow hedge contracts are excluded from the assessment of hedge effectiveness, and the gains and losses of the ineffective portions of these hedging instruments were not material for the three and nine months ended September 30, 2016 and 2015. As of September 30, 2016, the amounts expected to be reclassified out of AOCI and into earnings during the next 12 months are approximately $39 million of net gains on our foreign currency and cross-currency swap contracts and approximately $2 million of losses on forward interest rate contracts.

Fair value hedges

To achieve a desired mix of fixed and floating interest rates on our long-term debt, we entered into interest rate swap contracts that qualify and are designated as fair value hedges. The terms of these interest rate swap contracts correspond to the related hedged debt instruments and effectively convert a fixed interest rate coupon to a floating LIBOR-based coupon over the lives of the respective notes. We had interest rate swap agreements as of September 30, 2016, and December 31, 2015, with aggregate notional amounts of $6.65 billion. The contracts have rates that range from three-month LIBOR plus 0.4% to three-month LIBOR plus 2.0%.

For derivative instruments that qualify and are designated as fair value hedges, we recognize in current earnings the unrealized gain or loss on the derivative resulting from the change in fair value during the period as well as the offsetting unrealized loss or gain of the hedged item resulting from the change in fair value during the period attributable to the hedged risk. For the three and nine months ended September 30, 2016, we included the unrealized gains on hedged debt of $61 million and unrealized losses of $137 million, respectively, in the same line item, Interest expense, net, in the Condensed Consolidated Statements of Income, as the offsetting unrealized losses of $61 million and unrealized gains of $137 million, respectively, on the related interest rate swap agreements. For the three and nine months ended September 30, 2015, we included the unrealized losses on the hedged debt of $134 million and $140 million, respectively, in the same line item, Interest expense, net, in the Condensed Consolidated Statements of Income, as the offsetting unrealized gains of $134 million and $140 million, respectively, on the related interest rate swap agreements.

Derivatives not designated as hedges

To reduce our exposure to foreign currency fluctuations of certain assets and liabilities denominated in foreign currencies, we enter into foreign currency forward contracts that are not designated as hedging transactions. The exposures are hedged on a month-to-month basis. As of September 30, 2016, and December 31, 2015, the total notional amounts of these foreign currency forward contracts were $874 million and $911 million, respectively.

The location in the Condensed Consolidated Statements of Income and the amount of gain/(loss) recognized in earnings for our derivative instruments not designated as hedging instruments were as follows (in millions):



		Three months ended				Nine months ended
		September 30,				September 30,
Derivatives not designated as hedging instruments	Statements of Income location	2016		2015		2016			2015
Foreign currency contracts	Interest and other income, net	$	1	$	9	$	(33	)	$	—

The fair values of derivatives included in the Condensed Consolidated Balance Sheets were as follows (in millions):



	Derivative assets			Derivative liabilities
September 30, 2016	Balance Sheet location	Fair value		Balance Sheet location	Fair value
Derivatives designated as hedging instruments:
Foreign currency contracts	Other current assets/ Other noncurrent assets	$	43	Accrued liabilities/ Other noncurrent liabilities	$	34
Cross-currency swap contracts	Other current assets/ Other noncurrent assets	69		Accrued liabilities/ Other noncurrent liabilities	442
Interest rate swap contracts	Other current assets/ Other noncurrent assets	205		Accrued liabilities/ Other noncurrent liabilities	—
Total derivatives designated as hedging instruments		317			476
Derivatives not designated as hedging instruments:
Foreign currency contracts	Other current assets	—		Accrued liabilities	1
Total derivatives not designated as hedging instruments		—			1
Total derivatives		$	317		$	477



	Derivative assets			Derivative liabilities
December 31, 2015	Balance Sheet location	Fair value		Balance Sheet location	Fair value
Derivatives designated as hedging instruments:
Foreign currency contracts	Other current assets/ Other noncurrent assets	$	142	Accrued liabilities/ Other noncurrent liabilities	$	7
Cross-currency swap contracts	Other current assets/ Other noncurrent assets	—		Accrued liabilities/ Other noncurrent liabilities	250
Interest rate swap contracts	Other current assets/ Other noncurrent assets	71		Accrued liabilities/ Other noncurrent liabilities	3
Total derivatives designated as hedging instruments		213			260
Derivatives not designated as hedging instruments:
Foreign currency contracts	Other current assets	—		Accrued liabilities	1
Total derivatives not designated as hedging instruments		—			1
Total derivatives		$	213		$	261

Our derivative contracts that were in liability positions as of September 30, 2016, contain certain credit-risk-related contingent provisions that would be triggered if (i) we were to undergo a change in control and (ii) our or the surviving entity’s creditworthiness deteriorates, which is generally defined as having either a credit rating that is below investment grade or a materially weaker creditworthiness after the change in control. If these events were to occur, the counterparties would have the right, but not the obligation, to close the contracts under early-termination provisions. In such circumstances, the counterparties could request immediate settlement of these contracts for amounts that approximate the then current fair values of the contracts. In addition, our derivative contracts are not subject to any type of master netting arrangement, and amounts due to or from a counterparty under these contracts may be offset against other amounts due to or from the same counterparty only if an event of default or termination, as defined, were to occur.

The cash flow effects of our derivative contracts for the nine months ended September 30, 2016 and 2015, are included within Net cash provided by operating activities in the Condensed Consolidated Statements of Cash Flows.