Notes to Consolidated Financial Statements
7. Derivative Financial Instruments
Financial Contracts and Market Risk
We conduct business on a global basis in U.S. and foreign currencies, so our financial results are subject to risks associated with fluctuating foreign exchange rates. To mitigate these risks, we have a foreign currency exposure management program, which uses derivative foreign exchange contracts to address nonfunctional currency exposures that are expected to be settled in one year or less. We enter into derivative foreign exchange contracts only to the extent necessary to meet our goal of mitigating nonfunctional foreign currency exposures. We do not enter into hedging transactions for speculative purposes. The derivative foreign exchange contracts consist of foreign currency forward and option contracts.
Derivative financial contracts involve elements of market and credit risk not recognized in the financial statements. The market risk that results from these contracts relates to changes in foreign currency exchange rates, which generally are offset by changes in the value of the underlying assets or liabilities being held. Credit risk relates to the risk of nonperformance by a counterparty to one of our derivative contracts. We do not believe there is a significant credit risk associated with our hedging activities. We monitor the counterparties' credit ratings and other market data to minimize credit risk. In addition, we also limit the aggregate contract amount entered into with any one financial institution to mitigate credit risk.
We use derivative contracts to manage overall foreign currency exposures that are remeasured through income. We record these contracts on the balance sheet at fair value. Changes in the fair value of these contracts, excluding forward points, are included in earnings as part of Other expense, net. We had net losses of $2.4 million in 2008, net gains of $2.2 million in 2007 and net gains of $9.0 million in 2006. Receivables resulting from the contracts are included in Miscellaneous receivables and other current assets, while payables from the contracts are included as part of Other accrued liabilities. We recorded expense related to forward points in Other expense, net of $1.5 million in 2008, $1.0 million in 2007 and $1.5 million in 2006. We do not engage in hedging specific individual transactions. We held derivatives designated as non-designated hedges at the end of the year.
Our net foreign currency exposure is diversified among a broad number of currencies. The notional amounts reflected in the following table represent the U.S. dollar values of the agreed-upon amounts that will be delivered to a third party on the agreed-upon date:
Cash Flow Hedges
We use derivative contracts designated as cash flow hedges to mitigate currency risk related to an imbalance of nonfunctional currency denominated costs and related revenue. We conducted monthly effectiveness tests of our derivative contracts on a spot-to-spot basis, which excludes forward points. We recorded expense related to forward points in Other expense, net of $0.5 million in 2008, $0.4 million in 2007 and income of $0.4 million in 2006. Effective gains and losses from derivative contracts are recorded in Accumulated other comprehensive income until the underlying transactions are realized, at which point they are reclassified to Total cost of revenue. Ineffectiveness of derivative contracts is recorded to Other expense, net. We did not have any ineffective derivative contracts in 2008. We recorded a nominal amount of ineffectiveness in 2007. If it becomes probable that an anticipated transaction that is hedged will not occur, we immediately reclassify the gains or losses related to that hedge from Accumulated other comprehensive income to Other expense, net. At January 2, 2009, we had net unrealized gain of $2.9 million in Accumulated other comprehensive income, which is expected to be reclassified to income within the next 12 months at the prevailing market rate. We held derivatives designated as cash flow hedges at the end of the year.
Net Investment Hedges
During 2008, we entered into foreign currency forward contracts to hedge a portion of our net investment in one of our foreign subsidiaries to reduce economic currency risk. Changes in the fair value of these contracts due to Euro exchange rate fluctuations are recorded as foreign currency translation adjustments within Accumulated other comprehensive income. As of January 2, 2009, we had a net unrealized gain of $7.4 million in Accumulated other comprehensive income. We recorded expense related to forward points in Other expense, net of $0.6 million in 2008. We held net investment hedges for the aggregate contract amount of 100 million Euros at January 2, 2009.