X. Derivatives and Other Financial Instruments

Derivatives. Alcoa is exposed to certain risks relating to its ongoing business operations, including financial, market, political, and economic risks. The following discussion provides information regarding Alcoa's exposure to the risks of changing commodity prices, interest rates, and foreign currency exchange rates.

Alcoa's commodity and derivative activities are subject to the management, direction, and control of the Strategic Risk Management Committee (SRMC). The SRMC is composed of the chief executive officer, the chief financial officer, and other officers and employees that the chief executive officer selects. The SRMC reports to the Board of Directors on the scope of its activities.

The aluminum, energy, interest rate, and foreign exchange contracts are held for purposes other than trading. They are used primarily to mitigate uncertainty and volatility, and to cover underlying exposures. Alcoa is not involved in trading activities for energy, weather derivatives, or other nonexchange commodity trading activities.

The fair values of outstanding derivative contracts recorded as assets in the accompanying Consolidated Balance Sheet were as follows:


Asset Derivatives	December 31, 2011		December 31, 2010
Derivatives designated as hedging instruments:
Prepaid expenses and other current assets:
Aluminum contracts	$	56	$	48
Foreign exchange contracts		-		2
Interest rate contracts		8		19
Other noncurrent assets:
Aluminum contracts		6		22
Energy contracts		2		9
Interest rate contracts		37		62
Total derivatives designated as hedging instruments	$	109	$	162
Derivatives not designated as hedging instruments*:
Prepaid expenses and other current assets:
Aluminum contracts	$	1	$	3
Other noncurrent assets:
Aluminum contracts		5		-
Foreign exchange contracts		1		1
Total derivatives not designated as hedging instruments	$	7	$	4
Less margin held:
Prepaid expenses and other current assets:
Aluminum contracts	$	7	$	4
Interest rate contracts		8		13
Other noncurrent assets:
Interest rate contracts		7		2
Sub-total	$	22	$	19
Total Asset Derivatives	$	94	$	147

*	See the "Other" section within Note X for additional information on Alcoa's purpose for entering into derivatives not designated as hedging instruments and its overall risk management strategies.

The fair values of outstanding derivative contracts recorded as liabilities in the accompanying Consolidated Balance Sheet were as follows:


Liability Derivatives	December 31, 2011		December 31, 2010
Derivatives designated as hedging instruments:
Other current liabilities:
Aluminum contracts	$	79	$	89
Other noncurrent liabilities and deferred credits:
Aluminum contracts		574		647
Total derivatives designated as hedging instruments	$	653	$	736
Derivatives not designated as hedging instruments*:
Other current liabilities:
Aluminum contracts	$	35	$	52
Energy contracts		-		62
Other noncurrent liabilities and deferred credits:
Aluminum contracts		22		33
Embedded credit derivative		28		23
Total derivatives not designated as hedging instruments	$	85	$	170
Less margin posted:
Other current liabilities:
Aluminum contracts	$	1	$	4
Energy contracts		-		37
Sub-total	$	1	$	41
Total Liability Derivatives	$	737	$	865

*	See the "Other" section within Note X for additional information on Alcoa's purpose for entering into derivatives not designated as hedging instruments and its overall risk management strategies.

The following table shows the net fair values of outstanding derivative contracts at December 31, 2011 and the effect on these amounts of a hypothetical change (increase or decrease of 10%) in the market prices or rates that existed at December 31, 2011:


	Fair value asset/(liability)			Index change of + / - 10%
Aluminum contracts	$	(648	)	$	137
Embedded credit derivative		(28	)		9
Energy contracts		2			375
Foreign exchange contracts		1			-
Interest rate contracts		30			2

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:

•

Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

•

Level 2—Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g., interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

•

Level 3—Inputs that are both significant to the fair value measurement and unobservable.

The following section describes the valuation methodologies used by Alcoa to measure derivative contracts at fair value, including an indication of the level in the fair value hierarchy in which each instrument is generally classified. Where appropriate, the description includes details of the valuation models, the key inputs to those models, and any significant assumptions.

Derivative contracts are valued using quoted market prices and significant other observable and unobservable inputs. Such financial instruments consist of aluminum, energy, interest rate, and foreign exchange contracts. The fair values for the majority of these derivative contracts are based upon current quoted market prices. These financial instruments are typically exchange-traded and are generally classified within Level 1 or Level 2 of the fair value hierarchy depending on whether the exchange is deemed to be an active market or not.

For certain derivative contracts whose fair values are based upon trades in liquid markets, such as interest rate swaps, valuation model inputs can generally be verified and valuation techniques do not involve significant management judgment. The fair values of such financial instruments are generally classified within Level 2 of the fair value hierarchy.

Alcoa has other derivative contracts that do not have observable market quotes. For these financial instruments, management uses significant other observable inputs (e.g., information concerning time premiums and volatilities for certain option type embedded derivatives and regional premiums for aluminum contracts). For periods beyond the term of quoted market prices for aluminum, Alcoa uses a model that estimates the long-term price of aluminum by extrapolating the 10-year London Metal Exchange (LME) forward curve. For periods beyond the term of quoted market prices for energy, management has developed a forward curve based on independent consultant market research. Where appropriate, valuations are adjusted for various factors such as liquidity, bid/offer spreads, and credit considerations. Such adjustments are generally based on available market evidence (Level 2). In the absence of such evidence, management's best estimate is used (Level 3).

The following table presents Alcoa's derivative contract assets and liabilities that are measured and recognized at fair value on a recurring basis classified under the appropriate level of the fair value hierarchy (there were no transfers in or out of Levels 1 and 2 during the periods presented):


December 31,	2011			2010
Assets:
Level 1	$	57		$	76
Level 2		47			81
Level 3		12			9
Margin held*		(22	)		(19	)
Total	$	94		$	147
Liabilities:
Level 1	$	64		$	35
Level 2		44			83
Level 3		630			788
Margin posted*		(1	)		(41	)
Total	$	737		$	865

Margin held represents cash collateral received related to aluminum contracts included in Level 1 and interest rate contracts included in Level 2 and margin posted represents cash collateral paid related to aluminum contracts included in Level 1. At December 31, 2010, margin posted also represents cash collateral paid related to energy contracts included in Level 3. Alcoa elected to net the margin held and posted against the fair value amounts recognized for derivative instruments executed with the same counterparties under master netting arrangements.

Financial instruments classified as Level 3 in the fair value hierarchy represent derivative contracts in which management has used at least one significant unobservable input in the valuation model. The following table presents a reconciliation of activity for such derivative contracts on a net basis:


	2011			2010
Balance at beginning of year	$	779		$	831
Total gains or losses (realized and unrealized) included in:
Sales—(decrease)		(63	)		(38	)
Cost of goods sold—(increase)		(15	)		(20	)
Other (income) expenses, net—(increase) decrease		(43	)		25
Other comprehensive (loss) income—(increase)		(35	)		(19	)
Purchases, sales, issuances, and settlements*		(5	)		-
Transfers into and (or) out of Level 3**		-			-
Balance at end of year	$	618		$	779
Total gains or losses included in earnings attributable to the change in unrealized gains or losses relating to derivative contracts still held at December 31, 2011 and 2010:
Sales	$	-		$	-
Cost of goods sold		-			-
Other (income) expenses, net—(increase) decrease		(5	)		22

*	In 2011, there was an issuance of a Level 3 financial instrument related to a natural gas supply contract (see below). There were no purchases, sales, or settlements of Level 3 financial instruments in 2011 and 2010.

**	In 2011 and 2010, there were no transfers of financial instruments into or out of Level 3.

As reflected in the table above, the net unrealized loss on derivative contracts using Level 3 valuation techniques was $618 and $779 as of December 31, 2011 and 2010, respectively. These losses were mainly attributed to embedded derivatives in power contracts that index the price of power to the LME price of aluminum. These embedded derivatives are primarily valued using observable market prices. However, due to the length of the contracts, the valuation model also requires management to estimate the long-term price of aluminum based upon an extrapolation of the 10-year LME forward curve. The embedded derivatives have been designated as hedges of forward sales of aluminum and their realized gains and losses were included in Sales on the accompanying Statement of Consolidated Operations.

In 2011, Alcoa entered into a six-year natural gas supply contract, which has an LME-linked ceiling. This contract is valued using probabilities of future LME aluminum prices and the price of Brent crude oil (priced on Platts), including the interrelationships between the two commodities subject to the ceiling. At inception, this contract had a fair value of $5. Unrealized gains and losses from this contract were included in Other (income) expenses, net on the accompanying Statement of Consolidated Operations, while realized gains and losses will be included in Cost of goods sold on the accompanying Statement of Consolidated Operations as gas purchases are made under the contract.

Also, included within Level 3 measurements are derivative financial instruments that hedge the cost of electricity. Transactions involving on-peak power are observable as there is an active market. However, there are certain off-peak times when there is not an actively traded market for electricity. Therefore, management utilizes market prices, historical relationships, and various forecast services to determine the fair value. Management utilizes these same valuation techniques for an existing power contract associated with a smelter in the U.S. that no longer qualified for the normal purchase normal sale exception under derivative accounting in late 2009. Unrealized gains and losses for this physical power contract were included in Other (income) expenses, net on the accompanying Statement of Consolidated Operations, while realized gains and losses were included in Cost of goods sold on the accompanying Statement of Consolidated Operations. Additionally, a financial contract related to the same U.S. smelter utilized by management to hedge the price of electricity of the aforementioned power contract no longer qualified for cash flow hedge accounting near the end of 2009. Realized gains and losses of this financial contract were included in Cost of goods sold on the accompanying Statement of Consolidated Operations. In periods prior to January 1, 2010, unrealized gains and losses were included in Other comprehensive (loss) income; in periods subsequent to December 31, 2009, such changes were included in Other (income) expenses, net on the accompanying Statement of Consolidated Operations. Both the physical power contract and the financial contract related to this U.S. smelter expired in September 2011.

In 2010, Alcoa entered into contracts to hedge the anticipated power requirements at two smelters in Australia. These derivatives hedge forecasted power purchases through December 2036. Beyond the term where market information is available, management has developed a forward curve, for valuation purposes, based on independent consultant market research. The effective portion of gains and losses on these contracts were recorded in Other comprehensive (loss) income on the accompanying Consolidated Balance Sheet until the designated hedge periods begin in 2014 and 2016. Once the hedge periods begin, realized gains and losses will be recorded in Cost of goods sold.

Additionally, an embedded derivative in a power contract that indexes the difference between the long-term debt ratings of Alcoa and the counterparty from any of the three major credit rating agencies is included in Level 3. Management uses market prices, historical relationships, and forecast services to determine fair value. Realized gains and losses for this embedded derivative were included in Other (income) expenses, net on the accompanying Statement of Consolidated Operations.

Fair Value Hedges

For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the derivative as well as the loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings. The gain or loss on the hedged items are included in the same line items as the loss or gain on the related derivative contracts as follows (there were no contracts that ceased to qualify as a fair value hedge in 2011, 2010, or 2009):


Derivatives in Fair Value Hedging Relationships	Location of Gain or (Loss) Recognized in Earnings on Derivatives		Amount of Gain or (Loss) Recognized in Earnings on Derivatives
Derivatives in Fair Value Hedging Relationships			2011			2010			2009
Aluminum contracts		Sales	$	(126	)	$	38		$	214
Interest rate contracts		Interest expense		64			90			61
Total			$	(62	)	$	128		$	275

Hedged Items in Fair Value Hedging Relationships	Location of Gain or (Loss) Recognized in Earnings on Hedged Items		Amount of Gain or (Loss) Recognized in Earnings on Hedged Items
Hedged Items in Fair Value Hedging Relationships			2011			2010			2009
Aluminum contracts		Sales	$	133		$	(41	)	$	(227	)
Interest rate contracts		Interest expense		(31	)		(62	)		(61	)
Total			$	102		$	(103	)	$	(288	)

Aluminum. Alcoa is a leading global producer of primary aluminum and fabricated aluminum products. As a condition of sale, customers often require Alcoa to enter into long-term, fixed-price commitments. These commitments expose Alcoa to the risk of fluctuating aluminum prices between the time the order is committed and the time that the order is shipped. Alcoa's aluminum commodity risk management policy is to manage, principally through the use of futures and contracts, the aluminum price risk associated with a portion of its firm commitments. These contracts cover known exposures, generally within three years. As of December 31, 2011, Alcoa had 419 kmt of aluminum futures designated as fair value hedges. The effects of this hedging activity will be recognized over the designated hedge periods in 2012 to 2014.

Interest Rates. Alcoa uses interest rate swaps to help maintain a strategic balance between fixed- and floating-rate debt and to manage overall financing costs. As of December 31, 2011, the Company had pay floating, receive fixed interest rate swaps that were designated as fair value hedges. These hedges effectively convert the interest rate from fixed to floating on $515 of debt through 2018 (see Note K). In 2011, Alcoa terminated interest rate swaps with a notional amount of $550 in conjunction with the early retirement of the related debt (see Note K). At the time of termination, the swaps were "in-the-money" resulting in a gain of $33, which was recorded in Interest expense on the accompanying Statement of Consolidated Operations. In 2010, Alcoa terminated all or a portion of various interest rate swaps with a notional amount of $825 in conjunction with the early retirement of the related debt (see Note K). At the time of termination, the swaps were "in-the-money" resulting in a gain of $28, which was recorded in Interest expense on the accompanying Statement of Consolidated Operations.

Cash Flow Hedges

For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income (OCI) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in current earnings.


Derivatives in Cash Flow Hedging Relationships	Amount of Gain or (Loss) Recognized in OCI on Derivatives (Effective Portion)									Location of Gain or (Loss) Reclassified from Accumulated OCI into Earnings (Effective Portion)	Amount of Gain or (Loss) Reclassified from Accumulated OCI into Earnings (Effective Portion)*									Location of Gain or (Loss) Recognized in Earnings on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing)	Amount of Gain or (Loss) Recognized in Earnings on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing)**
	2011			2010			2009				2011			2010			2009				2011		2010		2009
Aluminum contracts	$	72		$	(6	)	$	(589	)	Sales	$	(114	)	$	(106	)	$	(4	)	Other (income) expenses, net	$	2	$	-	$	3
Aluminum contracts		-			-			13		Other (income) expenses, net		-			-			49		Other (income) expenses, net		-		-		-
Energy contracts		(3	)		(10	)		(29	)	Cost of goods sold		(8	)		(25	)		(37	)	Other (income) expenses, net		-		-		-
Foreign exchange contracts		1			(3	)		(2	)	Sales		4			(6	)		3		Other (income) expenses, net		-		-		-
Interest rate contracts		(2	)		(1	)		-		Interest expense		-			(1	)		-		Other (income) expenses, net		-		-		-
Interest rate contracts		(5	)		(1	)		(2	)	Other (income) expenses, net		(3	)		-			-		Other (income) expenses, net		-		-		-
Total	$	63		$	(21	)	$	(609	)		$	(121	)	$	(138	)	$	11			$	2	$	-	$	3

*	Assuming market rates remain constant with the rates at December 31, 2011, a gain of $22 is expected to be recognized in earnings over the next 12 months.

In 2011, 2010, and 2009, the amount of gain or (loss) recognized in earnings represents $(1), less than $1, and $3, respectively, related to the ineffective portion of the hedging relationships. There was also $3 recognized in earnings related to the amount excluded from the assessment of hedge effectiveness in 2011.

Aluminum and Energy. Alcoa anticipates the continued requirement to purchase aluminum and other commodities, such as electricity, natural gas, and fuel oil, for its operations. Alcoa enters into futures and forward contracts to reduce volatility in the price of these commodities. Alcoa has also entered into power supply and other contracts that contain pricing provisions related to the LME aluminum price. The LME-linked pricing features are considered embedded derivatives. A majority of these embedded derivatives have been designated as cash flow hedges of future sales of aluminum.

In 2010, Alcoa entered into contracts to hedge the anticipated power requirements at two smelters in Australia. These derivatives hedge forecasted power purchases through December 2036.

On March 31, 2009, Alcoa acquired an embedded derivative in a power contract, which is linked to the LME, in the Elkem transaction (see Note F).

Interest Rates. Alcoa had no outstanding cash flow hedges of interest rate exposures as of December 31, 2011, 2010, or 2009. An investment accounted for on the equity method by Alcoa has entered into interest rate contracts, which are designated as cash flow hedges. Alcoa's share of the activity of these cash flow hedges is reflected in the table above.

Foreign Exchange. Alcoa is subject to exposure from fluctuations in foreign currency exchange rates. These contracts may be used from time to time to hedge the variability in cash flows from the forecasted payment or receipt of currencies other than the functional currency. These contracts covered periods consistent with known or expected exposures through 2011. On March 31, 2009, Alcoa acquired foreign currency derivatives in the Elkem transaction (see Note F) which covered anticipated foreign currency exposures through 2011.

Alcoa had the following outstanding forward contracts that were entered into to hedge forecasted transactions:


December 31,	2011		2010
Aluminum contracts (kmt)		1,294		1,285
Energy contracts (electricity—megawatt hours)		100,578,295		100,578,295
Foreign exchange contracts	$	-	$	20

Other

Alcoa has also entered into certain derivatives to minimize its price risk related to other customer sales and pricing arrangements. Alcoa has not qualified these contracts for hedge accounting treatment and, therefore, the fair value gains and losses on these contracts are recorded in earnings as follows:


Derivatives Not Designated as Hedging Instruments	Location of Gain or (Loss) Recognized in Earnings on Derivatives	Amount of Gain or (Loss) Recognized in Earnings on Derivatives
Derivatives Not Designated as Hedging Instruments		2011			2010			2009
Aluminum contracts	Sales	$	(13	)	$	5		$	(9	)
Aluminum contracts	Other (income) expenses, net		13			(18	)		(38	)
Embedded credit derivative	Other (income) expenses, net		(5	)		(2	)		-
Energy contract	Other (income) expenses, net		47			(23	)		(30	)
Foreign exchange contracts	Other (income) expenses, net		(3	)		6			6
Total		$	39		$	(32	)	$	(71	)

The embedded credit derivative relates to a power contract that indexes the difference between the long-term debt ratings of Alcoa and the counterparty from any of the three major credit rating agencies. If the counterparty's lowest credit rating is greater than one rating category above Alcoa's credit ratings, an independent investment banker would be consulted to determine a hypothetical interest rate for both parties. The two interest rates would be netted and the resulting difference would be multiplied by Alcoa's equivalent percentage of the outstanding principal of the counterparty's debt obligation as of December 31 of the year preceding the calculation date. This differential would be added to the cost of power in the period following the calculation date.

In late 2009, an existing power contract associated with a smelter in the U.S. no longer qualified for the normal purchase normal sale exception under derivative accounting. The change in the classification of this contract was due to the fact that Alcoa negotiated a new power contract that did not replace the existing contract, resulting in Alcoa receiving more power than it requires for this smelter (the terms of the new power contract were favorable compared to the existing power contract and management determined that is was beneficial to enter into the new contract while fulfilling its obligation under the existing contract as opposed to waiting closer to the end of the existing contract to negotiate a new power contract). As a result, the existing contract was required to be accounted for as a derivative. Under the derivative classification, this contract did not qualify as a fair value or cash flow hedge. Additionally, a financial contract related to the same U.S. smelter utilized by management to hedge the price of electricity of the aforementioned power contract no longer qualified for cash flow hedge accounting. As such, the existing power contract and the financial contract were marked to market through earnings beginning in December 2009. Alcoa's obligations under the existing power contract and financial contract expired in September 2011.

In 2009, Alcoa entered into a forward contract to purchase $57 (C$58) to mitigate the foreign currency risk related to a Canadian-denominated loan due in 2014. All other foreign exchange contracts were entered into and settled within each of the periods presented.

Material Limitations

The disclosures with respect to commodity prices, interest rates, and foreign currency exchange risk do not take into account the underlying commitments or anticipated transactions. If the underlying items were included in the analysis, the gains or losses on the futures contracts may be offset. Actual results will be determined by a number of factors that are not under Alcoa's control and could vary significantly from those factors disclosed.

Alcoa is exposed to credit loss in the event of nonperformance by counterparties on the above instruments, as well as credit or performance risk with respect to its hedged customers' commitments. Although nonperformance is possible, Alcoa does not anticipate nonperformance by any of these parties. Contracts are with creditworthy counterparties and are further supported by cash, treasury bills, or irrevocable letters of credit issued by carefully chosen banks. In addition, various master netting arrangements are in place with counterparties to facilitate settlement of gains and losses on these contracts.

Other Financial Instruments. The carrying values and fair values of Alcoa's other financial instruments were as follows:


December 31,	2011				2010
December 31,	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	1,939	$	1,939	$	1,543	$	1,543
Restricted cash		25		25		1		1
Noncurrent receivables		30		30		23		23
Available-for-sale securities		92		92		93		93
Short-term borrowings		62		62		92		92
Commercial paper		224		224		-		-
Long-term debt due within one year		445		445		231		231
Long-term debt, less amount due within one year		8,640		9,274		8,842		9,882

The following methods were used to estimate the fair values of other financial instruments:

Cash and cash equivalents, Restricted cash, Short-term borrowings, Commercial paper, and Long-term debt due within one year. The carrying amounts approximate fair value because of the short maturity of the instruments.

Noncurrent receivables. The fair value of noncurrent receivables was based on anticipated cash flows, which approximates carrying value.

Available-for-sale securities. The fair value of such securities was based on quoted market prices. These financial instruments consist of exchange-traded fixed income and equity securities, which are carried at fair value and were classified in Level 1 of the fair value hierarchy.

Long-term debt, less amount due within one year. The fair value was based on quoted market prices for public debt and on interest rates that are currently available to Alcoa for issuance of debt with similar terms and maturities for non-public debt.