INTERNATIONAL PAPER CO /NEW/ | 2013 | FY | 3



International Paper periodically uses derivatives and other financial instruments to hedge exposures to interest rate, commodity and currency risks. International Paper does not hold or issue financial instruments for trading purposes. For hedges that meet the hedge accounting criteria, International Paper, at inception, formally designates and documents the instrument as a fair value hedge, a cash flow hedge or a net investment hedge of a specific underlying exposure.

INTEREST RATE RISK MANAGEMENT

Our policy is to manage interest cost using a mixture of fixed-rate and variable-rate debt. To manage this risk in a cost-efficient manner, we enter into interest rate swaps whereby we agree to exchange with the counterparty, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to a notional amount.

Interest rate swaps that meet specific accounting criteria are accounted for as fair value or cash flow hedges. For fair value hedges, the changes in the fair value of both the hedging instruments and the underlying debt obligations are immediately recognized in interest expense. For cash flow hedges, the effective portion of the changes in the fair value of the hedging instrument is reported in Accumulated other comprehensive income (“AOCI”) and reclassified into interest expense over the life of the underlying debt. The ineffective portion for both cash flow and fair value hedges, which is not material for any year presented, is immediately recognized in earnings.

FOREIGN CURRENCY RISK MANAGEMENT

We manufacture and sell our products and finance operations in a number of countries throughout the world and, as a result, are exposed to movements in foreign currency exchange rates. The purpose of our foreign currency hedging program is to manage the volatility associated with the changes in exchange rates.

To manage this exchange rate risk, we have historically utilized a combination of forward contracts, options and currency swaps. Contracts that qualify are designated as cash flow hedges of certain forecasted transactions denominated in foreign currencies. The effective portion of the changes in fair value of these instruments is reported in AOCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the related hedged transactions affect earnings. The ineffective portion, which is not material for any year presented, is immediately recognized in earnings.

In the second quarter of 2012, the Company added zero-cost collar option contracts to its portfolio to manage its exposure to U.S. dollar / Brazilian real exchange rates. These zero-cost collar instruments qualify as cash flow hedges of certain forecasted transactions denominated in U.S. dollars. The effective portion of the changes in fair value of these instruments is reported in AOCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the related hedged transactions affect earnings. The ineffective portion is immediately recognized in earnings.

The change in value of certain non-qualifying instruments used to manage foreign exchange exposure of intercompany financing transactions and certain balance sheet items subject to revaluation is immediately recognized in earnings, substantially offsetting the foreign currency mark-to-market impact of the related exposure.

COMMODITY RISK MANAGEMENT

Certain raw materials used in our production processes are subject to price volatility caused by weather, supply conditions, political and economic variables and other unpredictable factors. To manage the volatility in earnings due to price fluctuations, we may utilize swap contracts. These contracts are designated as cash flow hedges of forecasted commodity purchases. The effective portion of the changes in fair value for these instruments is reported in AOCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the hedged transactions affect earnings. The ineffective and non-qualifying portions, which are not material for any year presented, are immediately recognized in earnings.

The notional amounts of qualifying and non-qualifying instruments used in hedging transactions were as follows: 
In millions
December 31, 2013

December 31, 2012

 
Derivatives in Cash Flow Hedging Relationships:
 
 
 
Foreign exchange contracts (Sell / Buy; denominated in sell notional): (a)
 
 
 
Brazilian real / U.S. dollar - Forward
502


 
British pounds / Brazilian real - Forward
17

13

  
European euro / Brazilian real - Forward
27

13

  
European euro / Polish zloty - Forward
252

149

  
U.S. dollar / Brazilian real - Forward
290

238

  
U.S. dollar / Brazilian real - Zero-cost collar
18

18

 
Derivatives in Fair Value Hedging Relationships:
 
 
 
Interest rate contracts (in USD)
175


 
Derivatives Not Designated as Hedging Instruments:
 
 
 
Embedded derivative (in USD)

150

  
Foreign exchange contracts (Sell / Buy; denominated in sell notional):
 
 
 
Indian rupee / U.S. dollar
157

140

  
Thai baht / U.S. dollar

261

  
U.S. dollar / Turkish lira

56

  
Interest rate contracts (in USD)

150

(b)

(a)
These contracts had maturities of three years or less as of December 31, 2013.
(b)
Includes $150 million floating-to-fixed interest rate swap notional to offset the embedded derivative.

The following table shows gains or losses recognized in AOCI, net of tax, related to derivative instruments:
  
Gain (Loss)
Recognized in AOCI on Derivatives
(Effective Portion)
 
In millions
2013

2012

2011

Foreign exchange contracts
$

$
16

$
(39
)
Fuel oil contracts


2

Natural gas contracts

(1
)
(6
)
Total
$

$
15

$
(43
)


During the next 12 months, the amount of the December 31, 2013 AOCI balance, after tax, that is expected to be reclassified to earnings is a gain of $2 million.



The amounts of gains and losses recognized in the consolidated statement of operations on qualifying and non-qualifying financial instruments used in hedging transactions were as follows: 
  
Gain (Loss)
Reclassified from
AOCI
into Income
(Effective Portion)
 
 
Location of Gain
(Loss)
Reclassified
from AOCI
into Income
(Effective Portion)
In millions
2013

2012

2011

 
  
Derivatives in Cash Flow Hedging Relationships:
 
 
 
 
 
Foreign exchange contracts
$
7

$
(15
)
$
8

  
Cost of products sold
Fuel oil contracts


4

 
Cost of products sold
Natural gas contracts

(7
)
(20
)
 
Cost of products sold
Total
$
7

$
(22
)
$
(8
)
 
 
 
  
Gain (Loss)
Recognized
in Income
 
 
 
Location of Gain (Loss)
in Consolidated Statement of
Operations
In millions
2013

 
 
2012

 
 
2011

 
 
  
Derivatives in Fair Value Hedging Relationships:
 
 
 
 
 
 
 
 
 
 
Interest rate contracts
$
(1
)
 
 
$

  
 
$
(10
)
 
 
Interest expense, net
Debt
1

  
 

 
 
10

  
 
Interest expense, net
Total
$

  
 
$

  
 
$

  
 
 
Derivatives Not Designated as Hedging Instruments:
 
 
 
 
 
 
 
 
 
 
Electricity Contracts
$
4

 
 
$
(4
)
 
 
$

 
 
Cost of products sold
Embedded derivatives
(1
)
 
 
(4
)
  
 
(3
)
 
 
Interest expense, net
Foreign exchange contracts
(5
)
 
 


 
(14
)
(a)
 
Cost of products sold
Interest rate contracts
21

  
 
22

 
 
3

 
 
Interest expense, net
Total
$
19

 
 
$
14

  
 
$
(14
)
 
 
 


(a) Premium costs of $5 million in connection with the acquisition of APPM are included in Restructuring and other charges in the accompanying consolidated statement of operations.

The following activity is related to fully effective interest rate swaps designated as fair value hedges:
  




2013






2012


In millions
Issued

 
Terminated

 
Undesignated


Issued


Terminated

 
Undesignated

 
Fourth Quarter
$
175

  
$

  
$


$


$

  
$

  
Total
$
175

  
$

  
$


$


$

  
$

  


Fair Value Measurements

International Paper’s financial assets and liabilities that are recorded at fair value consist of derivative contracts, including interest rate swaps, foreign currency forward contracts, and other financial instruments that are used to hedge exposures to interest rate, commodity and currency risks. In addition, a consolidated subsidiary of International Paper has an embedded derivative. For these financial instruments and the embedded derivative, fair value is determined at each balance sheet date using an income approach.

The guidance for fair value measurements and disclosures sets out a fair value hierarchy that groups fair value measurement inputs into the following three classifications:

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market-based inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3: Unobservable inputs for the asset or liability reflecting the reporting entity’s own assumptions or external inputs from inactive markets.

Transfers between levels are recognized at the end of the reporting period. All of International Paper’s derivative fair value measurements use Level 2 inputs.

Below is a description of the valuation calculation and the inputs used for each class of contract:

Interest Rate Contracts

Interest rate contracts are valued using swap curves obtained from an independent market data provider. The market value of each contract is the sum of the fair value of all future interest payments between the contract counterparties, discounted to present value. The fair value of the future interest payments is determined by comparing the contract rate to the derived forward interest rate and present valued using the appropriate derived interest rate curve.

Fuel Oil Contracts

Fuel oil contracts are valued using the average of two forward fuel oil curves as quoted by third parties. The fair value of each contract is determined by comparing the strike price to the forward price of the corresponding fuel oil contract and present valued using the appropriate interest rate curve.

Natural Gas Contracts

Natural gas contracts are traded over-the-counter and settled using the NYMEX last day settle price; therefore, forward contracts are valued using the closing prices of the NYMEX natural gas future contracts. The fair value of each contract is determined by comparing the strike price to the closing price of the corresponding natural gas future contract and present valued using the appropriate interest rate curve.

Foreign Exchange Contracts

Foreign currency forward contracts are valued using foreign currency forward and interest rate curves obtained from an independent market data provider. The fair value of each contract is determined by comparing the contract rate to the forward rate. The fair value is present valued using the applicable interest rate from an independent market data provider.

Embedded Derivative

Embedded derivatives are valued using a hypothetical interest rate derivative with identical terms. The hypothetical interest rate derivative contracts are fair valued as described above under Interest Rate Contracts.

Since the volume and level of activity of the markets that each of the above contracts are traded in has been normal, the fair value calculations have not been adjusted for inactive markets or disorderly transactions.

The following table provides a summary of the impact of our derivative instruments in the consolidated balance sheet:

Fair Value Measurements
Level 2 – Significant Other Observable Inputs
 
  
Assets
 
 
Liabilities
 
 
In millions
December 31, 2013

 
December 31, 2012

 
December 31, 2013

 
December 31, 2012

 
Derivatives designated as hedging instruments
 
 
 
 
 
 
 
 
Foreign exchange contracts – cash flow
$
37

(a)
$
7

(c)
$
33

(d)
$
21

(f)
Interest rate contracts - fair value




1

(e)


Total derivatives designated as hedging instruments
$
37

  
$
7

  
$
34

  
$
21

  
Derivatives not designated as hedging instruments
 
 
 
 
 
 
 
 
Electricity contract
$
2

(b)
$

 
$


$
1

(g)
Embedded derivatives


1

(b)

  

  
Foreign exchange contracts


1

(b)

  

 
Interest rate contracts



  


1

(g)
Total derivatives not designated as hedging instruments
$
2

  
$
2

  
$

  
$
2

  
Total derivatives
$
39

  
$
9

  
$
34

  
$
23

  

(a)
Includes $23 million recorded in Other current assets and $14 million recorded in Deferred charges and other assets in the accompanying consolidated balance sheet.
(b)
Included in Other current assets in the accompanying consolidated balance sheet.
(c)
Includes $3 million recorded in Other current assets and $4 million recorded in Deferred charges and other assets in the accompanying consolidated balance sheet.
(d)
Includes $24 million recorded in Other accrued liabilities and $9 million recorded in Other liabilities in the accompanying consolidated balance sheet.
(e)
Included in Other liabilities in the accompanying consolidated balance sheet.
(f)
Includes $20 million recorded in Other accrued liabilities and $1 million recorded in Other liabilities in the accompanying consolidated balance sheet.
(g)
Included in Other accrued liabilities in the accompanying consolidated balance sheet.

The above contracts are subject to enforceable master netting arrangements that provide rights of offset with each counterparty when amounts are payable on the same date in the same currency or in the case of certain specified defaults. Management has made an accounting policy election to not offset the fair value of recognized derivative assets and derivative liabilities in the consolidated balance sheet. The amounts owed to the counterparties and owed to the Company are considered immaterial with respect to each counterparty and in the aggregate with all counterparties.

Credit-Risk-Related Contingent Features

International Paper evaluates credit risk by monitoring its exposure with each counterparty to ensure that exposure stays within acceptable policy limits. Credit risk is also mitigated by contractual provisions with the majority of our banks. Certain of the contracts include a credit support annex that requires the posting of collateral by the counterparty or International Paper based on each party’s rating and level of exposure. Based on the Company’s current credit rating, the collateral threshold is generally $10 million.

If the lower of the Company’s credit rating by Moody’s or S&P were to drop below investment grade, the Company would be required to post collateral for all of its derivatives in a net liability position, although no derivatives would terminate. The fair values of derivative instruments containing credit-risk-related contingent features in a net liability position were $3 million as of December 31, 2013 and $18 million as of December 31, 2012. The Company was not required to post any collateral as of December 31, 2013 or 2012.

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