Management's Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

Discussion and Analysis > Market Risk

ALG’s subsidiaries operate globally, with manufacturing and sales facilities in various locations around the world. ALG and its subsidiaries utilize certain financial instruments to manage foreign currency and commodity exposures. Derivative financial instruments are used by ALG and its subsidiaries, principally to reduce exposure to market risks resulting from fluctuations in foreign exchange rates and commodity prices, by creating offsetting exposures. Altria Group, Inc. is not a party to leveraged derivatives and, by policy, does not use derivative financial instruments for speculative purposes.

A substantial portion of Altria Group, Inc.’s derivative financial instruments is effective as hedges. Hedging activity affected accumulated other comprehensive earnings (losses), net of income taxes, during the years ended December 31, 2004, 2003 and 2002, as follows:

	(in millions)		2004				2003		2002
	(Loss) gain as of January 1		$(83)				$(77)		$  33
	Derivative losses (gains)
	transfered to earnings		86				(42)		1
	Change in fair value		(17)				36		(111)
	Loss as of December 31		$(14)				$(83)		$ (77)

The fair value of all derivative financial instruments has been calculated based on market quotes.

Foreign exchange rates: Altria Group, Inc. uses forward foreign exchange contracts and foreign currency options to mitigate its exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. The primary currencies to which Altria Group, Inc. is exposed include the Japanese yen, Swiss franc and the euro. At December 31, 2004 and 2003, Altria Group, Inc. had foreign exchange option and forward contracts with aggregate notional amounts of $9.7 billion and $13.6 billion, respectively. The $3.9 billion decrease from December 31, 2003, reflects $3.0 billion due to the maturity of a substantial portion of equal and offsetting foreign currency transactions discussed below, as well as the maturity of contracts that were outstanding at December 31, 2003, partially offset by new agreements in 2004. Included in the foreign currency aggregate notional amounts at December 31, 2004 and 2003, were $0.4 billion and $3.4 billion, respectively, of equal and offsetting foreign currency positions, which do not qualify as hedges and that will not result in any significant gain or loss. In addition, Altria Group, Inc. uses foreign currency swaps to mitigate its exposure to changes in exchange rates related to foreign currency denominated debt. These swaps typically convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. A substantial portion of the foreign currency swap agreements is accounted for as cash flow hedges. The unrealized gain (loss) relating to foreign currency swap agreements that do not qualify for hedge accounting treatment under U.S. GAAP was insignificant as of December 31, 2004 and 2003. At December 31, 2004 and 2003, the notional amounts of foreign currency swap agreements aggregated $2.7 billion and $2.5 billion, respectively.

Altria Group, Inc. also designates certain foreign currency denominated debt as net investment hedges of foreign operations. During the years ended December 31, 2004, 2003 and 2002, losses, net of income taxes, of $344 million, $286 million and $366 million, respectively, which represented effective hedges of net investments, were reported as a component of accumulated other comprehensive earnings (losses) within currency translation adjustments.

Commodities: Kraft is exposed to price risk related to forecasted purchases of certain commodities used as raw materials. Accordingly, Kraft uses commodity forward contracts as cash flow hedges, primarily for coffee, cocoa, milk and cheese. Commodity futures and options are also used to hedge the price of certain commodities, including milk, coffee, cocoa, wheat, corn, sugar and soybean oil. At December 31, 2004 and 2003, Kraft had net long commodity positions of $443 million and $255 million, respectively. In general, commodity forward contracts qualify for the normal purchase exception under U.S. GAAP. The effective portion of unrealized gains and losses on commodity futures and option contracts is deferred as a component of accumulated other comprehensive earnings (losses) and is recognized as a component of cost of sales when the related inventory is sold. Unrealized gains or losses on net commodity positions were immaterial at December 31, 2004 and 2003.



Value at Risk: Altria Group, Inc. uses a value at risk (“VAR”) computation to estimate the potential one-day loss in the fair value of its interest rate-sensitive financial instruments and to estimate the potential one-day loss in pre-tax earnings of its foreign currency and commodity price-sensitive derivative financial instruments. The VAR computation includes Altria Group, Inc.’s debt; short-term investments; foreign currency forwards, swaps and options; and commodity futures, forwards and options. Anticipated transactions, foreign currency trade payables and receivables, and net investments in foreign subsidiaries, which the foregoing instruments are intended to hedge, were excluded from the computation.

The VAR estimates were made assuming normal market conditions, using a 95% confidence interval. Altria Group, Inc. used a “variance/co-variance” model to determine the observed interrelationships between movements in interest rates and various currencies. These interrelationships were determined by observing interest rate and forward currency rate movements over the preceding quarter for the calculation of VAR amounts at December 31, 2004 and 2003, and over each of the four preceding quarters for the calculation of average VAR amounts during each year. The values of foreign currency and commodity options do not change on a one-to-one basis with the underlying currency or commodity, and were valued accordingly in the VAR computation.

The estimated potential one-day loss in fair value of Altria Group, Inc.’s interest rate-sensitive instruments, primarily debt, under normal market conditions and the estimated potential one-day loss in pre-tax earnings from foreign currency and commodity instruments under normal market conditions, as calculated in the VAR model, were as follows:

Pre-Tax Earnings Impact

At

(in millions)

12/31/04

Average

High

Low

Instruments sensitive to:

Foreign currency rates

$  16

$  21

$  35

$  16

Commodity prices

4

6

8

4

Fair Value Impact

At

(in millions)

12/31/04

Average

High

Low

Instruments sensitive to:

Interest rates

$72

$96

$113

$72

Pre-Tax Earnings Impact

At

(in millions)

12/31/03

Average

High

Low

Instruments sensitive to:

Foreign currency rates

$20

$35

$ 74

$20

Commodity prices

5

5

7

3

Fair Value Impact

At

(in millions)

12/31/03

Average

High

Low

Instruments sensitive to:

Interest rates

$119

$139

$171

$113

The VAR computation is a risk analysis tool designed to statistically estimate the maximum probable daily loss from adverse movements in interest rates, foreign currency rates and commodity prices under normal market conditions. The computation does not purport to represent actual losses in fair value or earnings to be incurred by Altria Group, Inc., nor does it consider the effect of favorable changes in market rates. Altria Group, Inc. cannot predict actual future movements in such market rates and does not present these VAR results to be indicative of future movements in such market rates or to be representative of any actual impact that future changes in market rates may have on its future results of operations or financial position.