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 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 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. 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 also uses 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. The unrealized gains or losses on these contracts are recorded in foreign currency translation adjustment within OCI, and remain in AOCI until either the sale or complete or substantially complete liquidation of the subsidiary. The Company excludes certain portions of the change in fair value of its derivative instruments from the assessment of hedge effectiveness (excluded component). Changes in fair value of the excluded components are recognized in OCI. In accordance with the new guidance adopted on January 1, 2018 (see Note 1), the Company has elected to recognize in earnings the initial value of the excluded component on a straight-line basis over the life of the derivative instrument, rather than using the mark-to-market approach. 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.

The effect of the Company’s net investment hedges on OCI and the Consolidated Statement of Income is shown below:



	Amount of Pretax (Gain) Loss Recognized in Other Comprehensive Income⁽¹⁾										Amount of Pretax (Gain) Loss Recognized in Other (income) expense, net for Amounts Excluded from Effectiveness Testing
	Three Months Ended June 30,					Six Months Ended June 30,					Three Months Ended June 30,					Six Months Ended June 30,
($ in millions)	2018			2017		2018			2017		2018			2017		2018			2017
Net Investment Hedging Relationships
Foreign exchange contracts	$	(12	)	$	—	$	(14	)	$	—	$	(3	)	$	—	$	(3	)	$	—
Euro-denominated notes	(271		)	204		(92		)	339		—			—		—			—

⁽¹⁾ No amounts were reclassified from AOCI into income related to the sale of a subsidiary.

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.

In May 2018, four interest rate swaps with notional amounts of $250 million each matured. These swaps effectively converted the Company’s $1.0 billion, 1.30% fixed-rate notes due 2018 to variable rate debt. At June 30, 2018, the Company was a party to 22 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.



	June 30, 2018
($ in millions)	Par Value of Debt	Number of Interest Rate Swaps Held	Total Swap Notional Amount
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 along with the offsetting 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.

The table below presents the location of amounts recorded on the Consolidated Balance Sheet related to cumulative basis adjustments for fair value hedges:



	Carrying Amount of Hedged Liabilities				Cumulative Amount of Fair Value Hedging Adjustment Increase (Decrease) Included in the Carrying Amount
($ in millions)	June 30, 2018		December 31, 2017		June 30, 2018			December 31, 2017
Balance Sheet Line Item in which Hedged Item is Included
Loans payable and current portion of long-term debt	$	554	$	983	$	5		$	(17	)
Long-Term Debt ⁽¹⁾	4,511		5,146		(129		)	(41		)

⁽¹⁾Amounts include hedging adjustment gains related to discontinued hedging relationships of $7 million and $11 million at June 30, 2018 and December 31, 2017, respectively.

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:



		June 30, 2018						December 31, 2017
		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	$	—	$	—	$	—	$	2	$	—	$	550
Interest rate swap contracts	Accrued and other current liabilities	—		2		550		—		3		1,000
Interest rate swap contracts	Other noncurrent liabilities	—		130		4,650		—		52		4,650
Foreign exchange contracts	Other current assets	153		—		6,071		51		—		4,216
Foreign exchange contracts	Other assets	83		—		2,561		38		—		1,936
Foreign exchange contracts	Accrued and other current liabilities	—		8		590		—		71		2,014
Foreign exchange contracts	Other noncurrent liabilities	—		1		144		—		1		20
		$	236	$	141	$	14,566	$	91	$	127	$	14,386
Derivatives Not Designated as Hedging Instruments
Foreign exchange contracts	Other current assets	$	208	$	—	$	6,403	$	39	$	—	$	3,778
Foreign exchange contracts	Accrued and other current liabilities	—		56		4,681		—		90		7,431
		$	208	$	56	$	11,084	$	39	$	90	$	11,209
		$	444	$	197	$	25,650	$	130	$	217	$	25,595

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:



	June 30, 2018						December 31, 2017
($ in millions)	Asset			Liability			Asset			Liability
Gross amounts recognized in the consolidated balance sheet	$	444		$	197		$	130		$	217
Gross amount subject to offset in master netting arrangements not offset in the consolidated balance sheet	(152		)	(152		)	(94		)	(94		)
Cash collateral received	(90		)	—			(3		)	—
Net amounts	$	202		$	45		$	33		$	123

The table below provides information regarding the location and amount of pretax (gains) losses of derivatives designated in fair value or cash flow hedging relationships:



	Sales					Other (income) expense, net ⁽¹⁾					Other comprehensive income (loss)						Sales				Other (income) expense, net⁽¹⁾						Other comprehensive income (loss)
	Three Months Ended June 30,					Three Months Ended June 30,					Three Months Ended June 30,						Six Months Ended June 30,				Six Months Ended June 30,						Six Months Ended June 30,
($ in millions)	2018			2017		2018			2017		2018			2017			2018		2017		2018			2017			2018		2017
Financial Statement Line Items in which Effects of Fair Value or Cash Flow Hedges are Recorded	$	10,465		$	9,930	$	(48	)	(73	)	$	(62	)	$	(14	)	20,502		$	19,365	$	(340	)	$	(143	)	$	62	$	132
(Gain) loss on fair value hedging relationships
Interest rate swap contracts
Hedged items	—			—		(15		)	20		—			—			—		—		(77		)	4			—		—
Derivatives designated as hedging instruments	—			—		22			(31	)	—			—			—		—		84			(27		)	—		—
Impact of cash flow hedging relationships
Foreign exchange contracts
Amount of gain (loss) recognized in OCI on derivatives	—			—		—			—		264			(169		)	—		—		—			—			84		(432		)
(Decrease) increase in Sales as a result of AOCI reclassifications	(73		)	49		—			—		73			(49		)	(166	)	144		—			—			166		(144		)

⁽¹⁾ Interest expense is a component of Other (income) expense, net.

The table below provides information regarding the income statement effects of derivatives not designated as hedging instruments:



		Amount of Derivative Pretax (Gain) Loss Recognized in Income
		Three Months Ended June 30,						Six Months Ended June 30,
($ in millions)	Income Statement Caption	2018			2017			2018			2017
Derivatives Not Designated as Hedging Instruments
Foreign exchange contracts⁽¹⁾	Other (income) expense, net	$	(195	)	$	(3	)	$	(167	)	$	(49	)
Foreign exchange contracts ⁽²⁾	Sales	(14		)	—			(5		)	—

⁽¹⁾ 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.

⁽²⁾ These derivative contracts serve as economic hedges of forecasted transactions.

At June 30, 2018, the Company estimates $29 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:



	June 30, 2018									December 31, 2017
	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	$	8,782	$	8,902	$	2	$	(122	)	$	9,806	$	9,837	$	9	$	(40	)
U.S. government and agency securities	1,620		1,640		—		(20		)	2,042		2,059		—		(17		)
Asset-backed securities	1,441		1,456		1		(16		)	1,542		1,548		1		(7		)
Foreign government bonds	649		658		—		(9		)	733		739		—		(6		)
Mortgage-backed securities	65		66		—		(1		)	626		634		1		(9		)
Commercial paper	30		30		—		—			159		159		—		—
Total debt securities	$	12,587	$	12,752	$	3	$	(168	)	$	14,908	$	14,976	$	11	$	(79	)
Publicly traded equity securities ⁽¹⁾	375									275		265		16		(6		)
Total debt and publicly traded equity securities	$	12,962								$	15,183	$	15,241	$	27	$	(85	)

⁽¹⁾Pursuant to the adoption of ASU 2016-01 (see Note 1), beginning on January 1, 2018, changes in the fair value of publicly traded equity securities are recognized in net income. Unrealized net gains of $7 million and $50 million, respectively, were recognized in Other (income) expense, net during the second quarter and first six months of 2018 on equity securities still held at June 30, 2018.

At June 30, 2018, the Company also had $675 million of equity investments without readily determinable fair values included in Other Assets. During the first six months of 2018, the Company recognized unrealized gains of $129 million on certain of these equity investments recorded in Other (income) expense, net based on favorable observable price changes from transactions involving similar investments of the same investee. In addition, during the first six months of 2018, the Company recognized unrealized losses of $26 million in Other (income) expense, net related to certain of these investments based on unfavorable observable price changes.

Available-for-sale debt securities included in Short-term investments totaled $2.3 billion at June 30, 2018. Of the remaining debt securities, $9.6 billion mature within five years. At June 30, 2018 and December 31, 2017, 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)	June 30, 2018								December 31, 2017
Assets
Investments
Corporate notes and bonds	$	—	$	8,684	$	—	$	8,684	$	—	$	9,678	$	—	$	9,678
U.S. government and agency securities	—		1,396		—		1,396		68		1,767		—		1,835
Asset-backed securities⁽¹⁾	—		1,394		—		1,394		—		1,476		—		1,476
Foreign government bonds	—		649		—		649		—		732		—		732
Commercial paper	—		30		—		30		—		159		—		159
Mortgage-backed securities	—		—		—		—		—		547		—		547
Publicly traded equity securities	164		—		—		164		104		—		—		104
	164		12,153		—		12,317		172		14,359		—		14,531
Other assets ⁽²⁾
U.S. government and agency securities	64		160		—		224		—		207		—		207
Corporate notes and bonds	—		98		—		98		—		128		—		128
Mortgage-backed securities	—		65		—		65		—		79		—		79
Asset-backed securities⁽¹⁾	—		47		—		47		—		66		—		66
Foreign government bonds	—		—		—		—		—		1		—		1
Publicly traded equity securities	211		—		—		211		171		—		—		171
	275		370		—		645		171		481		—		652
Derivative assets ⁽³⁾
Purchased currency options	—		142		—		142		—		80		—		80
Forward exchange contracts	—		302		—		302		—		48		—		48
Interest rate swaps	—		—		—		—		—		2		—		2
	—		444		—		444		—		130		—		130
Total assets	$	439	$	12,967	$	—	$	13,406	$	343	$	14,970	$	—	$	15,313
Liabilities
Other liabilities
Contingent consideration	$	—	$	—	$	830	$	830	$	—	$	—	$	935	$	935
Derivative liabilities ⁽³⁾
Forward exchange contracts	—		62		—		62		—		162		—		162
Interest rate swaps	—		132		—		132		—		55		—		55
Written currency options	—		3		—		3		—		—		—		—
	—		197		—		197		—		217		—		217
Total liabilities	$	—	$	197	$	830	$	1,027	$	—	$	217	$	935	$	1,152


⁽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.


⁽²⁾	Investments included in other assets are restricted as to use, primarily for the payment of benefits under employee benefit plans.


⁽³⁾	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 six months of 2018. As of June 30, 2018, Cash and cash equivalents of $5.3 billion included $4.5 billion of cash equivalents (which would be considered Level 2 in the fair value hierarchy).

Contingent Consideration

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



	Six Months Ended June 30,
($ in millions)	2018			2017
Fair value January 1	$	935		$	891
Changes in fair value⁽¹⁾	122			108
Additions	8			3
Payments	(235		)	—
Fair value June 30 ⁽²⁾	$	830		$	1,002

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

⁽²⁾ Balance at June 30, 2018 includes $92 million recorded as a current liability for amounts expected to be paid within the next 12 months.

The payments of contingent consideration in the first six months of 2018 include $175 million related to the achievement of a clinical milestone in connection with the 2016 acquisition of Afferent Pharmaceuticals. The remaining payments relate to liabilities recorded in connection with the 2016 termination of the Sanofi-Pasteur MSD joint venture.

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 June 30, 2018, was $23.9 billion compared with a carrying value of $23.3 billion and at December 31, 2017, was $25.6 billion compared with a carrying value of $24.4 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 global economic conditions, including the volatility associated with international sovereign economies, and associated impacts on the financial markets and its business. At June 30, 2018, the Company’s total net accounts receivable outstanding for more than one year were approximately $40 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 June 30, 2018 and December 31, 2017, the Company had received cash collateral of $90 million and $3 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 June 30, 2018 or December 31, 2017.