[40] Derivative financial instruments 

Merck uses derivative financial instruments exclusively to hedge currency and interest rate positions, and thereby reduce currency and interest rate risks. Foreign currency risks from recognized transactions are largely hedged. Merck currently uses marketable forward exchange contracts, interest rate futures and interest rate swaps as hedging instruments. Depending on the nature of the hedging transaction, hedged items are disclosed either in the operating result or, in the case of financial transactions, in the financial result.

The strategy to hedge interest rate and currency fluctuations arising from future transactions is set by a Merck Group currency and interest rate committee, which meets on a regular basis. A review period of up to 36 months normally serves as the basis for entering into currency derivative contracts. Extensive guidelines regulate the use of derivatives. There is a ban on speculation. Derivative transactions are subject to continuous risk management procedures. Trading, settlement and control functions are strictly separated. Derivative financial contracts are only entered into with banks that have a good credit rating.

The following derivative financial positions were held as of the balance sheet date:

The nominal volume is the aggregate of all buy and sell amounts relating to derivative contracts. The fair values result from the valuation of open positions at market prices, ignoring any opposite movements in the value of the underlyings. They correspond to the income or expenses which would result if the derivatives contract were closed out as of bthe alance sheet date. Transactions are recognized at fair value on the basis of quoted prices or current market data provided by a recognized information service.

The maturity structure of the hedging transactions (nominal volume) is as follows as of the balance sheet date:

The forward exchange contracts that are entered into to reduce the exchange rate risk with a total nominal volume of EUR 7,414.0  million primarily serve to hedge intercompany financing in foreign currency. These mainly served to hedge fluctuations in the exchange rates of the U.S. dollar (EUR 4,046.8 million), the Swiss franc (EUR 483.5 million), the Japanese yen (EUR 845.1 million), the Taiwanese dollar (EUR 533.2 million) and the British pound (EUR 494.7 million).

Forecast transactions are only in a cash flow hedging relationship if the occurrence can be assumed to be highly probable. The nominal volume of hedged future transactions amounted to EUR 3,713.5 million (2009: EUR 902.0 million) as of the balance sheet date and related mainly to the hedging of future sales in U.S. dollars, Taiwanese dollars and Japanese yen as well as costs in Swiss francs. The occurrence of hedged items is expected within the next 36 months. Moreover, we use forward exchange contracts to hedge financial investments and borrowings in foreign currency and designate them as cash flow hedges. During the fiscal year, expenses of EUR 125.3 million (2009: income totaling EUR 47.5 million) from the fair value measurement of derivatives was recognized in equity. EUR 17.2 million (2009: EUR 64.8 million) was transferred from equity and recognized as expense (2009: income).

The interest expense of the euro benchmark bond, which was issued in 2005 with a volume of EUR 500 million and a coupon of 3.75% was variabilized to the six-month Euribor through interest rate swaps and is measured as a fair value hedge. The fair value measurement of the bond led to income of EUR 0.2 million (2009: expense of EUR 15.2 million). This was offset by an expense in the same amount from the interest rate swap. Net interest payments on the bond and interest rate swaps were fixed in 2010 by forward exchange contracts based on the 6-month Euribor forward curve.

The interest expense of the private placement of EUR 100 million made in the context of the debt issuance program in 2009 was fixed by an interest rate swap of 3-month Euribor plus 0.77%, which was carried in the balance sheet as a cash flow hedge. The fair value measurement of the interest rate swap led to an expense of EUR 1.1 million (2009: 0.3 million). This amount was recognized in equity at 100% effectiveness.