N. Derivatives and Other Financial Instruments

Fair Value

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 (i) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (ii) 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.

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), which is composed of the chief executive officer, the chief financial officer, and other officers and employees that the chief executive officer selects. The SRMC meets on a periodic basis to review derivative positions and strategy and reports to Alcoa’s 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.

A number of Alcoa’s aluminum, energy, and foreign exchange contracts are classified as Level 1 and an interest rate contract is classified as Level 2 under the fair value hierarchy. These energy, foreign exchange, and interest rate contracts are not material to Alcoa’s Consolidated Financial Statements for all periods presented except as follows for a foreign exchange contract. Alcoa had a forward contract to purchase $231 (R$543) to mitigate the foreign currency risk associated with a potential future transaction denominated in Brazilian reais. This contract expired on March 31, 2014 and a loss of $4 was recognized in Other expenses, net on the accompanying Statement of Consolidated Operations in the 2014 first quarter.

For the aluminum contracts classified as Level 1, the total fair value of derivatives recorded as assets and liabilities was $6 and $54 and $2 and $31 at September 30, 2015 and December 31, 2014, respectively. These contracts were entered into to either hedge forecasted sales or purchases of aluminum in order to manage the associated aluminum price risk. Certain of these contracts are designated as hedging instruments, either fair value or cash flow, and the remaining are not designated as such. Combined, Alcoa recognized a net loss of $7 and a net gain of $34 in the 2015 third quarter and nine-month period, respectively, and a net loss of $2 and $15 in the 2014 third quarter and nine-month period, respectively, in Sales on the accompanying Statement of Consolidated Operations related to these aluminum contracts.

In addition to the Level 1 and 2 derivative instruments described above, Alcoa has nine derivative instruments classified as Level 3 under the fair value hierarchy. These instruments are composed of seven embedded aluminum derivatives, an energy contract, and an embedded credit derivative, all of which relate to energy supply contracts associated with eight smelters and three refineries. Five of the embedded aluminum derivatives and the energy contract were designated as cash flow hedging instruments and two of the embedded aluminum derivatives and the embedded credit derivative were not designated as hedging instruments.

The following section describes the valuation methodologies used by Alcoa to measure its Level 3 derivative instruments at fair value. Derivative instruments classified as Level 3 in the fair value hierarchy represent those in which management has used at least one significant unobservable input in the valuation model. Alcoa uses a discounted cash flow model to fair value all Level 3 derivative instruments. Where appropriate, the description below includes the key inputs to those models and any significant assumptions. These valuation models are reviewed and tested at least on an annual basis.

Inputs in the valuation models for Level 3 derivative instruments are composed of the following: (i) quoted market prices (e.g., aluminum prices on the 10-year London Metal Exchange (LME) forward curve and energy prices), (ii) significant other observable inputs (e.g., information concerning time premiums and volatilities for certain option type embedded derivatives and regional premiums for aluminum contracts), and (iii) unobservable inputs (e.g., aluminum and energy prices beyond those quoted in the market). For periods beyond the term of quoted market prices for aluminum, Alcoa estimates the price of aluminum by extrapolating the 10-year LME forward curve. Additionally, 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). If a significant input that is unobservable in one period becomes observable in a subsequent period, the related asset or liability would be transferred to the appropriate classification (Level 1 or 2) in the period of such change (there were no such transfers in the periods presented).

Alcoa has embedded derivatives in two power contracts that index the price of power to the LME price of aluminum. Additionally, in late 2014, Alcoa renewed three power contracts, each of which contain an embedded derivative that indexes the price of power to the LME price of aluminum plus the Midwest premium. The embedded derivatives in these five power contracts are primarily valued using observable market prices; however, due to the length of the contracts, the valuation models also require management to estimate the long-term price of aluminum based upon an extrapolation of the 10-year LME forward curve and/or 5-year Midwest premium curve. Significant increases or decreases in the actual LME price beyond 10 years and/or the Midwest premium beyond 5 years would result in a higher or lower fair value measurement. An increase in actual LME price and/or the Midwest premium over the inputs used in the valuation models will result in a higher cost of power and a corresponding decrease to the derivative asset or increase to the derivative liability. The embedded derivatives have been designated as cash flow hedges of forward sales of aluminum. Unrealized gains and losses were included in Other comprehensive loss on the accompanying Consolidated Balance Sheet while realized gains and losses were included in Sales on the accompanying Statement of Consolidated Operations.

Also, Alcoa has a power contract separate from above that contains an LME-linked embedded derivative. The embedded derivative is valued using the probability and interrelationship of future LME prices, Australian dollar to U.S. dollar exchange rates, and the U.S. consumer price index. Significant increases or decreases in the LME price would result in a higher or lower fair value measurement. An increase in actual LME price over the inputs used in the valuation model will result in a higher cost of power and a corresponding decrease to the derivative asset. This embedded derivative did not qualify for hedge accounting treatment. Unrealized gains and losses from the embedded derivative 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 as electricity purchases were made under the contract. At the time this derivative asset was recognized, an equivalent amount was recognized as a deferred credit in Other noncurrent liabilities and deferred credits on the accompanying Consolidated Balance Sheet. This deferred credit is recognized in Other (income) expenses, net on the accompanying Statement of Consolidated Operations as power is received over the life of the contract. Alcoa had a similar power contract and related embedded derivative associated with another smelter and rolling mill combined; however, the contract and related derivative instrument matured in July 2014.

Additionally, Alcoa has a natural gas supply contract, which has an LME-linked ceiling. This embedded derivative 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. Any change in the interrelationship would result in a higher or lower fair value measurement. An LME ceiling was embedded into the contract price to protect against an increase in the price of oil without a corresponding increase in the price of LME. An increase in oil prices with no similar increase in the LME price would limit the increase of the price paid for natural gas. This embedded derivative did not qualify for hedge accounting treatment. Unrealized gains and losses from the embedded derivative 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 as gas purchases were made under the contract.

Furthermore, Alcoa has 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. Management uses market prices, historical relationships, and forecast services to determine fair value. Significant increases or decreases in any of these inputs would result in a lower or higher fair value measurement. A wider credit spread between Alcoa and the counterparty would result in a higher cost of power and a corresponding increase in the derivative liability. This embedded derivative did not qualify for hedge accounting treatment. Unrealized gains and losses 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 as electricity purchases were made under the contract.

Finally, Alcoa has a derivative contract that will hedge the anticipated power requirements at one of its smelters once the existing power contract expires in 2016. Beyond the term where market information is available, management has developed a forward curve, for valuation purposes, based on independent consultant market research. Significant increases or decreases in the power market may result in a higher or lower fair value measurement. Lower prices in the power market would cause a decrease in the derivative asset. The derivative contract has been designated as a cash flow hedge of future purchases of electricity. Unrealized gains and losses on this contract were recorded in Other comprehensive loss on the accompanying Consolidated Balance Sheet. Once the designated hedge period begins in 2016, realized gains and losses will be recorded in Cost of goods sold as electricity purchases are made under the power contract.

The following table presents quantitative information related to the significant unobservable inputs described above for Level 3 derivative contracts:


	Fair value at September 30, 2015		Unobservable input	Range ($ in full amounts)
Assets:
Embedded aluminum derivatives	$	784	Price of aluminum beyond forward curve	Aluminum: $2,160 per metric ton in 2026 to $2,347 per metric ton in 2029 (two contracts) and $2,643 per metric ton in 2036 (one contract) Midwest premium: $0.0795 per pound in 2021 to $0.0795 per pound in 2029 (two contracts) and 2036 (one contract)
Embedded aluminum derivative		87	Interrelationship of future aluminum prices, foreign currency exchange rates, and the U.S. consumer price index (CPI)	Aluminum: $1,562 per metric ton in 2015 to $1,615 per metric ton in 2016 Foreign currency: A$1 = $0.70 in 2015 to $0.70 in 2016 CPI: 1982 base year of 100 and 235 in 2015 to 239 in 2016
Embedded aluminum derivative		4	Interrelationship of LME price to overall energy price	Aluminum: $1,560 per metric ton in 2015 to $1,817 per metric ton in 2019
Embedded aluminum derivative		—	Interrelationship of future aluminum and oil prices	Aluminum: $1,562 per metric ton in 2015 to $1,762 per metric ton in 2018 Oil: $47 per barrel in 2015 to $60 per barrel in 2018
Liabilities:
Embedded aluminum derivative		223	Price of aluminum beyond forward curve	Aluminum: $2,160 per metric ton in 2026 to $2,239 per metric ton in 2027
Embedded credit derivative		32	Credit spread between Alcoa and counterparty	3.04% to 3.50% (3.27% median)
Energy contract		5	Price of electricity beyond forward curve	Electricity: $45 per megawatt hour in 2018 to $121 per megawatt hour in 2036

The fair values of Level 3 derivative instruments recorded as assets and liabilities in the accompanying Consolidated Balance Sheet were as follows:


	September 30, 2015		December 31, 2014
Asset Derivatives
Derivatives designated as hedging instruments:
Prepaid expenses and other current assets:
Embedded aluminum derivatives	$	70	$	24
Other noncurrent assets:
Embedded aluminum derivative		718		73
Energy contract		—		2

Total derivatives designated as hedging instruments	$	788	$	99


Derivatives not designated as hedging instruments:
Prepaid expenses and other current assets:
Embedded aluminum derivatives	$	87	$	98
Other noncurrent assets:
Embedded aluminum derivatives		—		71

Total derivatives not designated as hedging instruments	$	87	$	169


Total Asset Derivatives	$	875	$	268


Liability Derivatives
Derivatives designated as hedging instruments:
Other current liabilities:
Embedded aluminum derivative	$	11	$	24
Other noncurrent liabilities and deferred credits:
Embedded aluminum derivatives		213		352
Energy contract		4		—

Total derivatives designated as hedging instruments	$	228	$	376


Derivatives not designated as hedging instruments:
Other current liabilities:
Embedded credit derivative	$	4	$	2
Other noncurrent liabilities and deferred credits:
Embedded credit derivative		28		16

Total derivatives not designated as hedging instruments	$	32	$	18


Total Liability Derivatives	$	260	$	394

The following tables present a reconciliation of activity for Level 3 derivative contracts:


	Assets					Liabilities
Third quarter ended September 30, 2015	Embedded aluminum derivatives			Energy contract		Embedded aluminum derivatives			Embedded credit derivative		Energy contract
Opening balance – July 1, 2015	$	680		$	—	$	298		$	19	$	9
Total gains or losses (realized and unrealized) included in:
Sales		(2	)		—		(3	)		—		—
Cost of goods sold		(25	)		—		—			—		—
Other income, net		(4	)		—		—			13		—
Other comprehensive loss		229			—		(72	)		—		(5	)
Purchases, sales, issuances, and settlements*		—			—		—			—		—
Transfers into and/or out of Level 3*		—			—		—			—		—
Foreign currency translation		(3	)		—		—			—		1

Closing balance – September 30, 2015	$	875		$	—	$	223		$	32	$	5


Change in unrealized gains or losses included in earnings for derivative contracts held at September 30, 2015:
Sales	$	—		$	—	$	—		$	—	$	—
Cost of goods sold		—			—		—			—		—
Other income, net		(4	)		—		—			13		—

*	There were no purchases, sales, issuances or settlements of Level 3 derivative instruments. Additionally, there were no transfers of derivative instruments into or out of Level 3.


	Assets						Liabilities
Nine months ended September 30, 2015	Embedded aluminum derivatives			Energy contract			Embedded aluminum derivatives			Embedded credit derivative		Energy contract
Opening balance – January 1, 2015	$	266		$	2		$	376		$	18	$	—
Total gains or losses (realized and unrealized) included in:
Sales		11			—			(14	)		—		—
Cost of goods sold		(70	)		—			—			—		—
Other income, net		(5	)		—			—			14		—
Other comprehensive loss		680			(2	)		(139	)		—		4
Purchases, sales, issuances, and settlements*		—			—			—			—		—
Transfers into and/or out of Level 3*		—			—			—			—		—
Foreign currency translation		(7	)		—			—			—		1

Closing balance – September 30, 2015	$	875		$	—		$	223		$	32	$	5


Change in unrealized gains or losses included in earnings for derivative contracts held at September 30, 2015:
Sales	$	—		$	—		$	—		$	—	$	—
Cost of goods sold		—			—			—			—		—
Other income, net		(5	)		—			—			14		—

*	There were no purchases, sales, issuances or settlements of Level 3 derivative instruments. Additionally, there were no transfers of derivative instruments into or out of Level 3.

Derivatives Designated As Hedging Instruments – Cash Flow Hedges

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

Alcoa has five Level 3 embedded aluminum derivatives and one Level 3 energy contract that have been designated as cash flow hedges as follows.

Embedded aluminum derivatives. Alcoa has entered into energy supply contracts that contain pricing provisions related to the LME aluminum price. The LME-linked pricing features are considered embedded derivatives. Five of these embedded derivatives have been designated as cash flow hedges of forward sales of aluminum, three of which were new derivatives contained in three power contracts that were renewed in late 2014. At September 30, 2015 and December 31, 2014, these embedded aluminum derivatives hedge forecasted aluminum sales of 3,369 kmt and 3,610 kmt, respectively.

In the 2015 third quarter and nine-month period and the 2014 third quarter and nine-month period, Alcoa recognized an unrealized gain of $301 and $819 and an unrealized loss of $4 and $28, respectively, in Other comprehensive loss related to these five derivative instruments. Additionally, Alcoa reclassified a realized loss of $1 and $25 and $8 and $19 from Accumulated other comprehensive loss to Sales in the 2015 third quarter and nine-month period and the 2014 third quarter and nine-month period, respectively. Assuming market rates remain constant with the rates at September 30, 2015, a realized gain of $41 is expected to be recognized in Sales over the next 12 months.

In the 2015 third quarter and nine-month period and the 2014 third quarter and nine-month period, Alcoa also recognized a gain of less than $1 and $2 and a loss of less than $1 and $1, respectively, in Other (income) expenses, net related to the amount excluded from the assessment of hedge effectiveness. There was no ineffectiveness related to these five derivative instruments in the 2015 third quarter and nine-month period and the 2014 third quarter and nine-month period.

Energy contract. Alcoa has a derivative contract that will hedge the anticipated power requirements at one of its smelters once the existing power contract expires in 2016. At September 30, 2015 and December 31, 2014, this energy contract hedges forecasted electricity purchases of 59,409,328 megawatt hours. In the 2015 third quarter and nine-month period and the 2014 third quarter and nine-month period, Alcoa recognized an unrealized gain of $3 and an unrealized loss of $8 and an unrealized loss of $28 and $10, respectively, in Other comprehensive loss. There was no ineffectiveness related to the energy contract in the 2015 third quarter and nine-month period and the 2014 third quarter and nine-month period.

Derivatives Not Designated As Hedging Instruments

Alcoa has two Level 3 embedded aluminum derivatives and one Level 3 embedded credit derivative that do not qualify for hedge accounting treatment. As such, gains and losses related to the changes in fair value of these instruments are recorded directly in earnings. In the third quarter of 2015 and 2014, Alcoa recognized a loss of $17 and $21, respectively, in Other (income) expenses, net, of which a loss of $4 and $11, respectively, related to the two embedded aluminum derivatives and a loss of $13 and $10, respectively, related to the embedded credit derivative. In the nine-month period of 2015 and 2014, Alcoa recognized a loss of $19 and $15, respectively, in Other (income) expenses, net, of which a loss of $5 and $12, respectively, related to the two embedded aluminum derivatives and a loss of $14 and $3, respectively, related to the embedded credit derivative.

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:


	September 30, 2015				December 31, 2014
	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	1,739	$	1,739	$	1,877	$	1,877
Restricted cash		24		24		20		20
Noncurrent receivables		17		17		17		17
Available-for-sale securities		177		177		153		153
Short-term borrowings		50		50		54		54
Commercial paper		—		—		—		—
Long-term debt due within one year		136		136		29		29
Long-term debt, less amount due within one year		9,091		9,062		8,769		9,445

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

Cash and cash equivalents, Restricted cash, Short-term borrowings, and Commercial paper. The carrying amounts approximate fair value because of the short maturity of the instruments. The fair value amounts for Cash and cash equivalents, Restricted cash, and Commercial paper were classified in Level 1, and Short-term borrowings were classified in Level 2.

Noncurrent receivables. The fair value of noncurrent receivables was based on anticipated cash flows, which approximates carrying value, and was classified in Level 2 of the fair value hierarchy.

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 due within one year and 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. The fair value amounts for all Long-term debt were classified in Level 2 of the fair value hierarchy.