Note 4: Financial Instruments

The company's consolidated results of operations are affected by changes in foreign exchange rates, interest rates and prices of commodity raw materials. The company uses non-leveraged derivative financial instruments to reduce the impact on the company's earnings of specific, known exposures to changes in exchange rates, interest rates and commodity prices. The company does not use derivative instruments for trading purposes. Credit risk associated with non-performance by counterparties is mitigated by only using major financial institutions with high credit ratings. The company also limits the amount of derivative contracts it enters into with each counterparty.

Foreign currency option and forward contracts are used to reduce foreign exchange rate risk. Purchased option contracts are utilized to hedge anticipated sales in foreign currencies by certain foreign subsidiaries. Gains and losses on purchased option contracts are deferred and included in income in the same period as the related sales, except for subsidiaries using their local currency as their functional currency. Those contracts, which amounted to approximately 32% and 25% of the total notional amount outstanding at December 31, 1997 and 1996, are marked to market at each balance sheet date. The notional amounts of currency option contracts totaled $118 and $114 million at December 31, 1997, and 1996, respectively.

At December 31, 1997, these included $40 million in German deutsche mark, $23 million in Italian lira, $38 million in Japanese yen and $17 million in other currencies. The contracts outstanding at each balance sheet date have maturities of less than eighteen months. At December 31, 1997 and 1996, net deferred unrealized gains were $4 million and $1 million, respectively.

Forward contracts are used to reduce the exchange rate risk of specific foreign currency transactions. These agreements require the exchange of a foreign currency for U.S. dollars at a fixed rate at a future date. The carrying amounts of foreign currency forward contracts were adjusted at each balance sheet date for changes in underlying exchange rates. There was one Japanese yen forward contract outstanding at December 31, 1997 with a notional value of $5 million and a maturity of less than twelve months. There were no forward contracts outstanding at December 31, 1996. At the end of both years, net unrealized gains and losses were immaterial.

The company uses various interest rate derivative instruments to manage its exposure to interest rate risk. At both December 31, 1997 and 1996, the company held an interest rate floor expiring in 1999 to hedge $50 million of its fixed-rate debt. The floor rate under this contract is 6.0%. The premium paid for the option is being amortized to interest expense over the option life. In early 1996, the company closed out an interest rate floor option then outstanding hedging $75 million of the company's fixed rate debt at a gain of $1 million.

At both December 31, 1997 and 1996, the company was a party to a written interest rate option contract with a notional amount of $25 million to monetize the call provision on the company's 9.375% debentures due 2019. The counterparty paid the company a premium of $5 million for the right to receive 9.375% fixed rate payments beginning 1999 through 2002. In return, the counterparty will pay the company variable interest payments based on six-month LIBOR. The written option has been marked to market through income at each balance sheet date.

At December 31, 1996, there were interest rate swap agreements outstanding with total notional amounts of $50 million, which expired in February 1997 at an immaterial amount of loss. The net swap position at December 31, 1996 converted $50 million of fixed-rate debt to floating-rate debt. The company was to receive fixed payments at 5.46% and pay at variable rates based on the six-month LIBOR. The differential between the fixed and floating rate amounts was accrued as an adjustment to interest expense. No interest swap agreements were outstanding at December 31, 1997.

The company uses commodity swap agreements for hedging purposes to reduce the effects of changing raw material prices. Gains and losses on the swap agreements are deferred until settlement and recorded as a component of underlying inventory costs when settled. The notional value of commodity swap agreements totaled $9 million and $1 million at December 31, 1997 and 1996, respectively. The company recorded net gains of $1 million in both 1997 and 1996.

The fair value of financial instruments was estimated based on the following methods and assumptions:

Cash and cash equivalents, accounts receivable, accounts payable and notes payable&emdash;the carrying amount approximates fair value due to the short maturity of these instruments.

Long-term debt--the fair value is estimated based on quoted market prices for the same or similar issues or the current rates offered to the company or its subsidiaries for debt with the same remaining maturities and terms.

Interest rate option contracts and swap agreements--the fair value is estimated based on quoted market prices of the same or similar issues available.

Foreign currency option contracts--the fair value is estimated based on the amount the company would receive or pay to terminate the contracts.

Foreign currency forward contracts--the carrying value approximates fair value because these contracts are adjusted to their market value at the balance sheet date.

Commodity swap agreements--the fair value is estimated based on the amount the company would receive or pay to terminate the contracts.

The carrying value and fair value of financial instruments at December 31, 1997, and 1996 are as follows:

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