O. 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:

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

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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.

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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.

For the aluminum contracts classified as Level 1, the total fair value of derivatives recorded as assets and liabilities was $6 and $11, respectively, at June 30, 2016 and $8 and $58, respectively, at December 31, 2015. 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 gain of $1 and $3 in the 2016 second quarter and six-month period, respectively, and a net gain of $15 and $41 in the 2015 second quarter and six-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 ten derivative instruments classified as Level 3 under the fair value hierarchy. These instruments are composed of eight embedded aluminum derivatives, an energy contract, and an embedded credit derivative, all of which relate to energy supply contracts associated with nine smelters and three refineries. Five of the embedded aluminum derivatives and the energy contract were designated as cash flow hedging instruments and three 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 two power contracts, each of which contain an embedded derivative that indexes the price of power to the LME price of aluminum. Additionally, Alcoa has 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) income 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 (expires in September 2016 – see below) 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, 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, net on the accompanying Statement of Consolidated Operations as power is received over the life of the contract.

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, 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.

In the second quarter of 2016, Alcoa and the related counterparty elected to modify the pricing of an existing power contract for a smelter in the United States. This amendment contains an embedded derivative that now indexes the price of power to the LME price of aluminum plus the Midwest premium. The embedded derivative is valued using the interrelationship of future metal prices (LME base plus Midwest premium) and the amount of megawatt hours of energy needed to produce the forecasted metric tons of aluminum at the smelter. Significant increases or decreases in the metal price would result in a higher or lower fair value measurement. An increase in actual metal price over the inputs used in the valuation model will result in a higher cost of power and a corresponding increase to the derivative liability. Management elected not to qualify the embedded derivative for hedge accounting treatment. Unrealized gains and losses from the embedded derivative will be included in Other income, 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 electricity purchases are made under the contract. At the time this derivative liability was recognized, an equivalent amount was recognized as a deferred charge in Other noncurrent assets on the accompanying Consolidated Balance Sheet. This deferred charge will be recognized in Other income, net on the accompanying Statement of Consolidated Operations as power is received over the life of the contract.

Furthermore, Alcoa has a power contract, which contains an embedded derivative 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, 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 September 2016 (see above). 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) income on the accompanying Consolidated Balance Sheet. Once the designated hedge period begins in September 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 June 30, 2016*		Unobservable input	Range ($ in full amounts)
Assets:
Embedded aluminum derivatives	$	718	Price of aluminum beyond forward curve	Aluminum: $2,093 per metric ton in 2026 to $2,245 per metric ton in 2029 (two contracts) and $2,540 per metric ton in 2036 (one contract) Midwest premium: $0.0775 per pound in 2021 to $0.0775 per pound in 2029 (two contracts) and 2036 (one contract)
Embedded aluminum derivative		23	Interrelationship of future aluminum prices, foreign currency exchange rates, and the U.S. consumer price index (CPI)	Aluminum: $1,631 per metric ton in July 2016 to $1,637 per metric ton in September 2016 Foreign currency: A$1 = $0.74 in 2016 (July through September) CPI: 1982 base year of 100 and 236 in 2016 (July through September)
Embedded aluminum derivative		4	Interrelationship of LME price to overall energy price	Aluminum: $1,614 per metric ton in 2016 to $1,755 per metric ton in 2019
Embedded aluminum derivative		—	Interrelationship of future aluminum and oil prices	Aluminum: $1,631 per metric ton in 2016 to $1,710 per metric ton in 2018 Oil: $49 per barrel in 2016 to $55 per barrel in 2018
Energy contract		40	Price of electricity beyond forward curve	Electricity: $48 per megawatt hour in 2019 to $116 per megawatt hour in 2036
Liabilities:
Embedded aluminum derivative		196	Price of aluminum beyond forward curve	Aluminum: $2,093 per metric ton in 2026 to $2,137 per metric ton in 2027
Embedded aluminum derivative		32	Interrelationship of LME price to the amount of megawatt hours of energy needed to produce the forecasted metric tons of aluminum	Aluminum: $1,631 per metric ton in 2016 to $1,729 per metric ton in 2019 Midwest premium: $0.0725 per pound in 2016 to $0.0775 per pound in 2019 Electricity: rate at 2 million megawatt hours per year
Embedded credit derivative		33	Credit spread between Alcoa and counterparty	3.45% to 3.81% (3.63% median)

The fair value of the energy contract reflected as an asset in this table is lower by $9 compared to the respective amount reflected in the Level 3 tables presented below. This is due to the fact that this contract is in a liability position for the current portion but is in an asset position for the noncurrent portion, and is reflected as such on the accompanying Consolidated Balance Sheet. However, this derivative is reflected as a net asset in the above table for purposes of presenting the assumptions utilized to measure the fair value of the derivative instrument in its entirety.

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


	June 30, 2016		December 31, 2015
Asset Derivatives
Derivatives designated as hedging instruments:
Prepaid expenses and other current assets:
Embedded aluminum derivatives	$	51	$	72
Other noncurrent assets:
Embedded aluminum derivatives		671		994
Energy contract		49		2

Total derivatives designated as hedging instruments	$	771	$	1,068

Derivatives not designated as hedging instruments:
Prepaid expenses and other current assets:
Embedded aluminum derivatives	$	23	$	69

Total derivatives not designated as hedging instruments	$	23	$	69

Total Asset Derivatives	$	794	$	1,137

Liability Derivatives
Derivatives designated as hedging instruments:
Other current liabilities:
Embedded aluminum derivative	$	14	$	9
Energy contract		9		4
Other noncurrent liabilities and deferred credits:
Embedded aluminum derivative		182		160

Total derivatives designated as hedging instruments	$	205	$	173

Derivatives not designated as hedging instruments:
Other current liabilities:
Embedded aluminum derivative	$	8	$	—
Embedded credit derivative		5		6
Other noncurrent liabilities and deferred credits:
Embedded aluminum derivative		24		—
Embedded credit derivative		28		29

Total derivatives not designated as hedging instruments	$	65	$	35

Total Liability Derivatives	$	270	$	208

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


	Assets					Liabilities
Second quarter ended June 30, 2016	Embedded aluminum derivatives			Energy contract		Embedded aluminum derivative			Embedded credit derivative			Energy contract
Opening balance – April 1, 2016	$	988		$	6	$	161		$	33		$	11
Total gains or losses (realized and unrealized) included in:
Sales		(3	)		—		(3	)		—			—
Cost of goods sold		(30	)		—		—			(2	)		—
Other income, net		(4	)		—		—			2			—
Other comprehensive loss		(215	)		37		38			—			(8	)
Purchases, sales, issuances, and settlements*		—			—		32			—			—
Transfers into and/or out of Level 3*		—			—		—			—			—
Other		9			6		—			—			6

Closing balance – June 30, 2016	$	745		$	49	$	228		$	33		$	9

Change in unrealized gains or losses included in earnings for derivative contracts held at June 30, 2016:
Sales	$	—		$	—	$	—		$	—		$	—
Cost of goods sold		—			—		—			—			—
Other income, net		(4	)		—		—			2			—

In the 2016 second quarter, there was an issuance of a new embedded derivative contained in an amendment to an existing power contract. There were no purchases, sales or settlements of Level 3 derivative instruments. Additionally, there were no transfers of derivative instruments into or out of Level 3.


	Assets					Liabilities
Six months ended June 30, 2016	Embedded aluminum derivatives			Energy contract		Embedded aluminum derivative			Embedded credit derivative			Energy contract
Opening balance – January 1, 2016	$	1,135		$	2	$	169		$	35		$	4
Total gains or losses (realized and unrealized) included in:
Sales		(10	)		—		(5	)		—			—
Cost of goods sold		(61	)		—		—			(3	)		—
Other income, net		(8	)		2		—			1			(1	)
Other comprehensive income		(336	)		39		32			—			—
Purchases, sales, issuances, and settlements*		—			—		32			—			—
Transfers into and/or out of Level 3*		—			—		—			—			—
Other		25			6		—			—			6

Closing balance – June 30, 2016	$	745		$	49	$	228		$	33		$	9

Change in unrealized gains or losses included in earnings for derivative contracts held at June 30, 2016:
Sales	$	—		$	—	$	—		$	—		$	—
Cost of goods sold		—			—		—			—			—
Other income, net		(8	)		2		—			1			(1	)

In the 2016 six-month period, there was an issuance of a new embedded derivative contained in an amendment to an existing power contract. There were no purchases, sales 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. At June 30, 2016 and December 31, 2015, these embedded aluminum derivatives hedge forecasted aluminum sales of 3,261 kmt and 3,307 kmt, respectively.

Alcoa recognized a net unrealized loss of $253 and $368 in the 2016 second quarter and six-month period, respectively, and a net unrealized gain of $616 and $518 in the 2015 second quarter and six-month period, respectively, in Other comprehensive (loss) income related to these five derivative instruments. Additionally, Alcoa reclassified a realized gain of less than $1 and $5 in the 2016 second quarter and six-month period, respectively, and a realized loss of $12 and $24 in the 2015 second quarter and six-month period, respectively, from Accumulated other comprehensive loss to Sales. Assuming market rates remain constant with the rates at June 30, 2016, a realized gain of $25 is expected to be recognized in Sales over the next 12 months.

Also, Alcoa recognized a gain of less than $1 in the 2016 six-month period (no such gain was recognized in the 2016 second quarter) and a gain of less than $1 and $1 in the 2015 second quarter and six-month period, respectively, in Other income, net related to the amount excluded from the assessment of hedge effectiveness. There was no ineffectiveness related to these five derivative instruments in the 2016 second quarter and six-month period and the 2015 second quarter and six-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 September 2016. At June 30, 2016 and December 31, 2015, this energy contract hedges forecasted electricity purchases of 59,409,328 megawatt hours. Alcoa recognized an unrealized gain of $45 and $39 in the 2016 second quarter and six-month period, respectively, and an unrealized loss of $17 and $11 in the 2015 second quarter and six-month period, respectively, in Other comprehensive (loss) income. Additionally, Alcoa recognized a gain of $3 in Other income, net related to hedge ineffectiveness in the 2016 six-month period. There was no ineffectiveness related to the energy contract in the 2016 second quarter and the 2015 second quarter and six-month period.

Derivatives Not Designated As Hedging Instruments

Alcoa has three 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 second quarter of 2016 and 2015, Alcoa recognized a loss of $6 and $5, respectively, in Other income, net, of which a loss of $4 and $2, respectively, related to the embedded aluminum derivatives and a loss of $2 and $3, respectively, related to the embedded credit derivative. In the six-month period of 2016 and 2015, Alcoa recognized a loss of $9 and $2, respectively, in Other income, net, of which a loss of $8 and $1, respectively, related to the embedded aluminum derivatives and a loss of $1 and $1, 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:


	June 30, 2016				December 31, 2015
	Carrying value		Fair value		Carrying value		Fair value
Cash and cash equivalents	$	1,929	$	1,929	$	1,919	$	1,919
Restricted cash		30		30		37		37
Noncurrent receivables		19		19		17		17
Available-for-sale securities		68		68		193		193
Short-term borrowings		33		33		38		38
Commercial paper		—		—		—		—
Long-term debt due within one year		774		791		21		21
Contingent payment related to an acquisition		132		132		130		130
Long-term debt, less amount due within one year		8,278		8,670		8,993		8,922

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.

Contingent payment related to an acquisition. The fair value was based on the net present value of expected future cash flows and was classified in Level 3 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.