This excerpt taken from the AES 10-K filed Mar 17, 2008.
9. DERIVATIVE INSTRUMENTS
AES utilizes derivative financial instruments to hedge interest rate risk, foreign exchange risk and commodity price risk. The Company utilizes interest rate swap, cap and floor agreements to hedge interest rate risk on floating rate debt. Most of AES's interest rate derivatives are designated and qualify as cash flow hedges. Currency forwards, options and swap agreements are utilized by the Company to hedge foreign exchange risk. The Company utilizes electric and fuel derivative instruments, including swaps, options, forwards and futures, to hedge the risk related to electricity sales and fuel purchases. Most of AES's electric and fuel derivatives are designated and qualify as cash flow hedges.
Certain derivatives are not designated as hedging instruments, primarily because they do not qualify for hedge accounting treatment as defined by SFAS No. 133. While these instruments economically hedge interest rate risk, foreign exchange risk or commodity price risk, they do contain certain features, primarily the inclusion of written options, which cause them to not qualify for hedge accounting.
Amounts recognized in accumulated other comprehensive loss due to hedges, after income taxes, during the years ended December 31, 2007, 2006, and 2005, respectively are as follows:
Approximately $23 million of the accumulated other comprehensive loss related to derivative instruments as of December 31, 2007 is expected to be recognized as a decrease to income from continuing operations over the next twelve months. This estimate includes estimated gains (losses) of $2 million, $(1) million and $(23) million related to foreign currency, commodity and interest rate instruments, respectively. The balance in accumulated other comprehensive loss related to derivative transactions will be reclassified into earnings as interest expense is recognized for hedges of interest rate risk, as depreciation is recognized for hedges of capitalized interest, as foreign currency transaction and translation gains and losses are recognized for hedges of foreign currency exposure, and as electric and gas sales and purchases are recognized for hedges of forecasted electric and fuel transactions.
The maximum length of time over which AES is hedging its exposure to variability in future cash flows for forecasted interest, foreign currency and commodity transactions is 15 years, 3 years and 23 years, respectively. For the years ended December 31, 2007, 2006, and 2005, (losses) gains of $(2) million, $3 million, and $0, respectively, were reclassified into earnings as a result of the discontinuance of a cash flow hedge because it was probable that the forecasted transaction would not occur. For the years ended December 31, 2007 and 2006 no fair value hedges were discontinued. The Company recognized after-tax gains of $6 million, $18 million, and $20 million related to the ineffective portion of derivatives qualifying as cash flow and fair value hedges for the years ended December 31, 2007, 2006, and 2005, respectively. The ineffective portion is recognized as interest income or expense for interest rate hedges, foreign currency gains or losses on foreign currency hedges, and non-regulated revenue or non-regulated cost of sales for commodity hedges.
THE AES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2007, 2006, AND 2005
9. DERIVATIVE INSTRUMENTS (Continued)
After-tax (losses) gains related to the changes in fair value of derivatives that do not qualify for hedge accounting were $(21) million, $22 million and $(63) million for the years ended December 31, 2007, 2006 and 2005, respectively. The after-tax losses include embedded foreign currency derivatives, interest rate swaps and options, commodity derivatives and embedded derivatives. Gains or losses on derivatives that do not qualify for hedge accounting are recognized as interest income or expense for interest rate derivatives, foreign currency gains or losses on foreign currency derivatives, and revenue or cost of sales for commodity derivatives. The balances in the Consolidated Balance Sheets related to derivative assets and liabilities are further discussed in Note 13Fair Value of Financial Instruments.