[59] Derivative financial instruments Audited

Merck uses derivative financial instruments exclusively to hedge and reduce risks stemming from currency and interest rate positions. Foreign currency risks from recognized transactions are largely hedged. Merck currently uses marketable forward exchange contracts, interest rate swaps and currency options as hedging instruments. Depending on the nature of the hedging transaction, changes in the fair values of hedged items are disclosed in the income statement either in the operating result or, in the case of financial transactions, in the financial result. The strategy to hedge interest rate and foreign exchange rate fluctuations arising from future transactions is set by a Merck Group risk 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. Related default risks are continuously monitored.

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

The stated fair values for derivatives do not include accrued interest (clean price).

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 the balance 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 and currency options primarily serve to hedge intercompany financing in foreign currency as well as to hedge future cash flows. These mainly served to hedge fluctuations in the exchange rates of the U.S. dollar (€ 4,409.6 million), the Japanese yen (€ 458.4 million) and the Taiwan dollar (€ 388.4 million) versus the euro.

Planned future transactions are only hedged if the occurrence can be assumed to be highly probable. The nominal volume of hedged planned transactions amounted to € 2,411.6 million (2011: € 2,829.8 million) as of the balance sheet date and related to both the hedging of future transactions in non-functional currency as well as hedging of variable interest payments for planned refinancing transactions. Moreover, existing monetary deposits and borrowings in foreign currency as well as an existing variable interest private placement with a nominal amount of € 100.0 million were also hedged. All the aforementioned hedging relationships represented cash flow hedges.

Overall, income of € 3.6 million (2011: expenses of € 50.1 million) from the fair value measurement of derivatives to hedge cash flows was recognized in equity in 2012. € 78.4 million (2011: € 12.3 million) was transferred from equity and recognized as an expense. In 2012, no ineffectiveness for hedging transactions was recognized in income.

The hedging of planned transactions in non-functional currency related to sales in U.S. dollars, Taiwan dollars and Japanese yen that are expected within the next 36 months. Forward exchange contracts and currency options are used as hedging instruments.

For the planned refinancing of the bond maturing in 2015, we entered into forward interest rate swap contracts with a nominal value of € 550.0 million to hedge the interest rate level. The fair value was recognized in equity at 100% effectiveness. In addition, interest rate hedge contracts with a nominal volume of € 250.0 million for bonds due in 2012 were closed out since refinancing did not occur. The resulting expenses from the fair value of the hedge amounting to € 26.7 million were reported in the financial result.

Furthermore, a fair value hedge existed in 2012. The interest expense of the euro benchmark bond issued in 2005 and maturing in 2012 with a volume of € 500.0 million was made variable through interest rate swaps. The mark-to-market measurement of the bond resulted in income of € 5.4 million in 2012 (2011: € 10.0 million). This compared with an expense from the interest rate swap in the same amount.