Financial Instruments

Derivative Instruments and Hedging Activities

The Company manages the impact of foreign exchange rate movements and interest rate movements on its earnings, cash flows and fair values of assets and liabilities through operational means and through the use of various financial instruments, including derivative instruments.

A significant portion of the Company’s revenues and earnings in foreign affiliates is exposed to changes in foreign exchange rates. The objectives and accounting related to the Company’s foreign currency risk management program, as well as its interest rate risk management activities are discussed below.

Foreign Currency Risk Management

The Company has established revenue hedging, balance sheet risk management and net investment hedging programs to protect against volatility of future foreign currency cash flows and changes in fair value caused by volatility in foreign exchange rates.

The objective of the revenue hedging program is to reduce the variability caused by changes in foreign exchange rates that would affect the U.S. dollar value of future cash flows derived from foreign currency denominated sales, primarily the euro and Japanese yen. To achieve this objective, the Company will hedge a portion of its forecasted foreign currency denominated third-party and intercompany distributor entity sales (forecasted sales) that are expected to occur over its planning cycle, typically no more than two years into the future. The Company will layer in hedges over time, increasing the portion of forecasted sales hedged as it gets closer to the expected date of the forecasted foreign currency denominated sales. The portion of forecasted sales hedged is based on assessments of cost-benefit profiles that consider natural offsetting exposures, revenue and exchange rate volatilities and correlations, and the cost of hedging instruments. The Company manages its anticipated transaction exposure principally with purchased local currency put options, forward contracts and purchased collar options.

The fair values of these derivative contracts are recorded as either assets (gain positions) or liabilities (loss positions) in the Condensed Consolidated Balance Sheet. Changes in the fair value of derivative contracts are recorded each period in either current earnings or Other comprehensive income (OCI), depending on whether the derivative is designated as part of a hedge transaction and, if so, the type of hedge transaction. For derivatives that are designated as cash flow hedges, the effective portion of the unrealized gains or losses on these contracts is recorded in Accumulated other comprehensive income (AOCI) and reclassified into Sales when the hedged anticipated revenue is recognized. The hedge relationship is highly effective and hedge ineffectiveness has been de minimis. For those derivatives which are not designated as cash flow hedges, but serve as economic hedges of forecasted sales, unrealized gains or losses are recorded in Sales each period. The cash flows from both designated and non-designated contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows. The Company does not enter into derivatives for trading or speculative purposes.

The Company manages operating activities and net asset positions at each local subsidiary in order to mitigate the effects of exchange on monetary assets and liabilities. The Company also uses a balance sheet risk management program to mitigate the exposure of net monetary assets that are denominated in a currency other than a subsidiary’s functional currency from the effects of volatility in foreign exchange. In these instances, Merck principally utilizes forward exchange contracts to offset the effects of exchange on exposures denominated in developed country currencies, primarily the euro and Japanese yen. For exposures in developing country currencies, the Company will enter into forward contracts to partially offset the effects of exchange on exposures when it is deemed economical to do so based on a cost-benefit analysis that considers the magnitude of the exposure, the volatility of the exchange rate and the cost of the hedging instrument. The cash flows from these contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows.

Monetary assets and liabilities denominated in a currency other than the functional currency of a given subsidiary are remeasured at spot rates in effect on the balance sheet date with the effects of changes in spot rates reported in Other (income) expense, net. The forward contracts are not designated as hedges and are marked to market through Other (income) expense, net. Accordingly, fair value changes in the forward contracts help mitigate the changes in the value of the remeasured assets and liabilities attributable to changes in foreign currency exchange rates, except to the extent of the spot-forward differences. These differences are not significant due to the short-term nature of the contracts, which typically have average maturities at inception of less than one year.

The Company may also use forward exchange contracts to hedge its net investment in foreign operations against movements in exchange rates. The forward contracts are designated as hedges of the net investment in a foreign operation. The Company hedges a portion of the net investment in certain of its foreign operations and measures ineffectiveness based upon changes in spot foreign exchange rates that are recorded in Other (income) expense, net. The effective portion of the unrealized gains or losses on these contracts is recorded in foreign currency translation adjustment within OCI, and remains in AOCI until either the sale or complete or substantially complete liquidation of the subsidiary. The cash flows from these contracts are reported as investing activities in the Condensed Consolidated Statement of Cash Flows.

Foreign exchange risk is also managed through the use of foreign currency debt. The Company’s senior unsecured euro-denominated notes have been designated as, and are effective as, economic hedges of the net investment in a foreign operation. Accordingly, foreign currency transaction gains or losses due to spot rate fluctuations on the euro-denominated debt instruments are included in foreign currency translation adjustment within OCI. Included in the cumulative translation adjustment are pretax losses of $135 million and $58 million for the first three months of 2017 and 2016, respectively, from the euro-denominated notes.

Interest Rate Risk Management

The Company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rate changes and to reduce its overall cost of borrowing. The Company does not use leveraged swaps and, in general, does not leverage any of its investment activities that would put principal capital at risk.

At March 31, 2017, the Company was a party to 26 pay-floating, receive-fixed interest rate swap contracts designated as fair value hedges of fixed-rate notes in which the notional amounts match the amount of the hedged fixed-rate notes as detailed in the table below.



($ in millions)	March 31, 2017
Debt Instrument	Par Value of Debt		Number of Interest Rate Swaps Held	Total Swap Notional Amount
1.30% notes due 2018	$	1,000	4	$	1,000
5.00% notes due 2019	1,250		3	550
1.85% notes due 2020	1,250		5	1,250
3.875% notes due 2021	1,150		5	1,150
2.40% notes due 2022	1,000		4	1,000
2.35% notes due 2022	1,250		5	1,250

The interest rate swap contracts are designated hedges of the fair value changes in the notes attributable to changes in the benchmark London Interbank Offered Rate (LIBOR) swap rate. The fair value changes in the notes attributable to changes in the LIBOR swap rate are recorded in interest expense and offset by the fair value changes in the swap contracts. The cash flows from these contracts are reported as operating activities in the Condensed Consolidated Statement of Cash Flows.

Presented in the table below is the fair value of derivatives on a gross basis segregated between those derivatives that are designated as hedging instruments and those that are not designated as hedging instruments:



		March 31, 2017						December 31, 2016
		Fair Value of Derivative				U.S. Dollar Notional		Fair Value of Derivative				U.S. Dollar Notional
($ in millions)	Balance Sheet Caption	Asset		Liability		U.S. Dollar Notional		Asset		Liability		U.S. Dollar Notional
Derivatives Designated as Hedging Instruments
Interest rate swap contracts	Other assets	$	11	$	—	$	2,700	$	20	$	—	$	2,700
Interest rate swap contracts	Other noncurrent liabilities	—		35		3,500		—		29		3,500
Foreign exchange contracts	Other current assets	330		—		5,049		616		—		6,063
Foreign exchange contracts	Other assets	56		—		1,815		129		—		2,075
Foreign exchange contracts	Accrued and other current liabilities	—		21		915		—		1		48
Foreign exchange contracts	Other noncurrent liabilities	—		1		20		—		1		12
		$	397	$	57	$	13,999	$	765	$	31	$	14,398
Derivatives Not Designated as Hedging Instruments
Foreign exchange contracts	Other current assets	$	232	$	—	$	8,037	$	230	$	—	$	8,210
Foreign exchange contracts	Accrued and other current liabilities	—		89		6,479		—		103		2,931
		$	232	$	89	$	14,516	$	230	$	103	$	11,141
		$	629	$	146	$	28,515	$	995	$	134	$	25,539

As noted above, the Company records its derivatives on a gross basis in the Condensed Consolidated Balance Sheet. The Company has master netting agreements with several of its financial institution counterparties (see Concentrations of Credit Risk below). The following table provides information on the Company’s derivative positions subject to these master netting arrangements as if they were presented on a net basis, allowing for the right of offset by counterparty and cash collateral exchanged per the master agreements and related credit support annexes:



	March 31, 2017						December 31, 2016
($ in millions)	Asset			Liability			Asset			Liability
Gross amounts recognized in the consolidated balance sheet	$	629		$	146		$	995		$	134
Gross amount subject to offset in master netting arrangements not offset in the consolidated balance sheet	(144		)	(144		)	(131		)	(131		)
Cash collateral received	(222		)	—			(529		)	—
Net amounts	$	263		$	2		$	335		$	3

The table below provides information on the location and pretax gain or loss amounts for derivatives that are: (i) designated in a fair value hedging relationship, (ii) designated in a foreign currency cash flow hedging relationship and (iii) not designated in a hedging relationship:



	Three Months Ended March 31,
($ in millions)	2017			2016
Derivatives designated in a fair value hedging relationship
Interest rate swap contracts
Amount of loss (gain) recognized in Other (income) expense, net on derivatives ⁽¹⁾	$	15		$	(150	)
Amount of (gain) loss recognized in Other (income) expense, net on hedged item ⁽¹⁾	(16		)	147
Derivatives designated in foreign currency cash flow hedging relationships
Foreign exchange contracts
Amount of gain reclassified from AOCI to Sales	(94		)	(143		)
Amount of loss recognized in OCI on derivatives	263			167
Derivatives not designated in a hedging relationship
Foreign exchange contracts
Amount of (gain) loss recognized in Other (income) expense, net on derivatives ⁽²⁾	(47		)	24

⁽¹⁾There was $1 million and $3 million of ineffectiveness on the hedge during the first quarter of 2017 and 2016, respectively.

⁽²⁾ These derivative contracts mitigate changes in the value of remeasured foreign currency denominated monetary assets and liabilities attributable to changes in foreign currency exchange rates.

At March 31, 2017, the Company estimates $167 million of pretax net unrealized gains on derivatives maturing within the next 12 months that hedge foreign currency denominated sales over that same period will be reclassified from AOCI to Sales. The amount ultimately reclassified to Sales may differ as foreign exchange rates change. Realized gains and losses are ultimately determined by actual exchange rates at maturity.

Investments in Debt and Equity Securities

Information on investments in debt and equity securities is as follows:



	March 31, 2017									December 31, 2016
	Fair Value		Amortized Cost		Gross Unrealized					Fair Value		Amortized Cost		Gross Unrealized
($ in millions)	Fair Value		Amortized Cost		Gains		Losses			Fair Value		Amortized Cost		Gains		Losses
Corporate notes and bonds	$	10,445	$	10,455	$	19	$	(29	)	$	10,577	$	10,601	$	15	$	(39	)
U.S. government and agency securities	2,011		2,021		1		(11		)	2,232		2,244		1		(13		)
Asset-backed securities	1,410		1,411		2		(3		)	1,376		1,380		1		(5		)
Commercial paper	773		773		—		—			4,330		4,330		—		—
Mortgage-backed securities	712		717		—		(5		)	796		801		1		(6		)
Foreign government bonds	560		561		1		(2		)	519		521		—		(2		)
Equity securities	356		278		79		(1		)	349		281		71		(3		)
	$	16,267	$	16,216	$	102	$	(51	)	$	20,179	$	20,158	$	89	$	(68	)

Available-for-sale debt securities included in Short-term investments totaled $3.5 billion at March 31, 2017. Of the remaining debt securities, $10.6 billion mature within five years. At March 31, 2017 and December 31, 2016, there were no debt securities pledged as collateral.

Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company uses a fair value hierarchy which maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. There are three levels of inputs used to measure fair value with Level 1 having the highest priority and Level 3 having the lowest:

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 - Unobservable inputs that are supported by little or no market activity. Level 3 assets or liabilities are those whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques with significant unobservable inputs, as well as assets or liabilities for which the determination of fair value requires significant judgment or estimation.

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis

Financial assets and liabilities measured at fair value on a recurring basis are summarized below:



	Fair Value Measurements Using								Fair Value Measurements Using
	Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
($ in millions)	March 31, 2017								December 31, 2016
Assets
Investments
Corporate notes and bonds	$	—	$	10,287	$	—	$	10,287	$	—	$	10,389	$	—	$	10,389
U.S. government and agency securities	66		1,647		—		1,713		29		1,890		—		1,919
Asset-backed securities⁽¹⁾	—		1,312		—		1,312		—		1,257		—		1,257
Commercial paper	—		773		—		773		—		4,330		—		4,330
Mortgage-backed securities ⁽¹⁾	—		595		—		595		—		628		—		628
Foreign government bonds	—		559		—		559		—		518		—		518
Equity securities	198		—		—		198		201		—		—		201
	264		15,173		—		15,437		230		19,012		—		19,242
Other assets
U.S. government and agency securities	—		298		—		298		—		313		—		313
Corporate notes and bonds	—		158		—		158		—		188		—		188
Mortgage-backed securities ⁽¹⁾	—		117		—		117		—		168		—		168
Asset-backed securities⁽¹⁾	—		98		—		98		—		119		—		119
Foreign government bonds	—		1		—		1		—		1		—		1
Equity securities	158		—		—		158		148		—		—		148
	158		672		—		830		148		789		—		937
Derivative assets ⁽²⁾
Purchased currency options	—		354		—		354		—		644		—		644
Forward exchange contracts	—		264		—		264		—		331		—		331
Interest rate swaps	—		11		—		11		—		20		—		20
	—		629		—		629		—		995		—		995
Total assets	$	422	$	16,474	$	—	$	16,896	$	378	$	20,796	$	—	$	21,174
Liabilities
Other liabilities
Contingent consideration	$	—	$	—	$	925	$	925	$	—	$	—	$	891	$	891
Derivative liabilities ⁽²⁾
Forward exchange contracts	—		110		—		110		—		93		—		93
Interest rate swaps	—		35		—		35		—		29		—		29
Written currency options	—		1		—		1		—		12		—		12
	—		146		—		146		—		134		—		134
Total liabilities	$	—	$	146	$	925	$	1,071	$	—	$	134	$	891	$	1,025

⁽¹⁾

Primarily all of the asset-backed securities are highly-rated (Standard & Poor’s rating of AAA and Moody’s Investors Service rating of Aaa), secured primarily by auto loan, credit card and student loan receivables, with weighted-average lives of primarily 5 years or less. Mortgage-backed securities represent AAA-rated securities issued or unconditionally guaranteed as to payment of principal and interest by U.S. government agencies.


⁽²⁾	The fair value determination of derivatives includes the impact of the credit risk of counterparties to the derivatives and the Company’s own credit risk, the effects of which were not significant.

There were no transfers between Level 1 and Level 2 during the first three months of 2017. As of March 31, 2017, Cash and cash equivalents of $11.7 billion included $10.9 billion of cash equivalents (considered Level 2 in the fair value hierarchy).

Contingent Consideration

Summarized information about the changes in liabilities for contingent consideration is as follows:



	Three Months Ended March 31,
($ in millions)	2017		2016
Fair value January 1	$	891	$	590
Changes in fair value⁽¹⁾	34		10
Additions	—		77
Payments	—		(25		)
Fair value March 31	$	925	$	652

⁽¹⁾ Recorded in Research and development expenses, Materials and production costs and Other (income) expense, net. Includes cumulative translation adjustments.

The additions to contingent consideration in the first quarter of 2016 relate to the acquisition of IOmet (see Note 2). The payments of contingent consideration in the first quarter of 2016 relate to the first commercial sale of Zerbaxa in the European Union.

Other Fair Value Measurements

Some of the Company’s financial instruments, such as cash and cash equivalents, receivables and payables, are reflected in the balance sheet at carrying value, which approximates fair value due to their short-term nature.

The estimated fair value of loans payable and long-term debt (including current portion) at March 31, 2017, was $29.3 billion compared with a carrying value of $28.5 billion and at December 31, 2016, was $25.7 billion compared with a carrying value of $24.8 billion. Fair value was estimated using recent observable market prices and would be considered Level 2 in the fair value hierarchy.

Concentrations of Credit Risk

On an ongoing basis, the Company monitors concentrations of credit risk associated with corporate and government issuers of securities and financial institutions with which it conducts business. Credit exposure limits are established to limit a concentration with any single issuer or institution. Cash and investments are placed in instruments that meet high credit quality standards as specified in the Company’s investment policy guidelines.

The majority of the Company’s accounts receivable arise from product sales in the United States and Europe and are primarily due from drug wholesalers and retailers, hospitals, government agencies, managed health care providers and pharmacy benefit managers. The Company monitors the financial performance and creditworthiness of its customers so that it can properly assess and respond to changes in their credit profile. The Company also continues to monitor economic conditions, including the volatility associated with international sovereign economies, and associated impacts on the financial markets and its business, taking into consideration global economic conditions and the ongoing sovereign debt issues in certain European countries. At March 31, 2017, the Company’s total net accounts receivable outstanding for more than one year were approximately $135 million. The Company does not expect to have write-offs or adjustments to accounts receivable which would have a material adverse effect on its financial position, liquidity or results of operations.

Derivative financial instruments are executed under International Swaps and Derivatives Association master agreements. The master agreements with several of the Company’s financial institution counterparties also include credit support annexes. These annexes contain provisions that require collateral to be exchanged depending on the value of the derivative assets and liabilities, the Company’s credit rating, and the credit rating of the counterparty. As of March 31, 2017 and December 31, 2016, the Company had received cash collateral of $222 million and $529 million, respectively, from various counterparties and the obligation to return such collateral is recorded in Accrued and other current liabilities. The Company had not advanced any cash collateral to counterparties as of March 31, 2017 or December 31, 2016.