QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our policy prohibits the use of derivative instruments for trading purposes and we have procedures in place to monitor and control their use. Our current use of derivative instruments in primarily limited to interest rate swaps and commodity futures contracts.
Interest rate swaps are entered into with the objective of converting variable to fixed rate debt, thereby reducing volatility in borrowing costs. In 1997, we entered into interest rate swaps to effectively converts a portion of our variable rate bank debt to fixed rate. Payment dates and the floating rates on the swaps match those of the underlying bank debt. Our credit risk related to interest rate swaps in dependent upon both the movement in the interest rates and the possibility of non-payment by swap counterparties. We mitigate credit by only entering into the swap agreements with high credit-quality counterparties and netting swap payments within each contract.
Commodity futures contracts traded on national exchanges are entered into with the objective of reducing food costs. While this hedging activity has historically been limited, hedging activity could increase in the future if we believe it would result in lower total costs. Open contracts, deferred gains and losses and realized gains and losses were not significant for all years presented.
Our primary market risk exposure with regard to financial instruments is to changes in interest rates, principally in the United States. In addition, a portion of our debt is denominated in foreign currencies which exposes us to market risk associated with exchange rate movements. Historically, we have not used derivative financial instruments to manage our exposure to foreign currency rate fluctuations since the market risk associated with our foreign currency denominated debt was not considered significant.
At December 27, 1997, a hypothetical 100 basis point increase a short-term interest rates would result in a reduction of $33 million in annual pre-tax earnings. The estimated reduction is based upon the unhedged portion of our variable rate debt and assumes no change in the volume or composition of debt at December 27, 1997. In addition, the fair value of our interest rate derivative contracts would increase approximately $25 million. Fair value was determined by discounting the projected interest rate swap cash flows.
From time to time, in both written reports and oral statements, we present "forward-looking statements" within the meaning of Federal and state securities laws, including those identified by such words as "may," "will," "expect," "believe," "plan" and other similar terminology. These "forward-looking statements" reflect our current expectations and are based upon data available at the time of the statements. Actual results involve risks and uncertainties, including both those specific to the Company and those specific to the industry, and could differ materially from expectations.
Company risks and uncertainties include but are not limited to the lack of experience of our management group in operating the Company as an independent, publicly owned business; potentially substantial tax contingencies related to the Spin-off, which, if they occur, require us to indemnify PepsiCo; our substantial debt leverage and the attendant potential restriction on our ability to borrow in the future, as well as the substantial interest expense and principal repayment obligations; potentials unfavorable variances between estimated and actual liabilities both as contained in the PepsiCo-prepared balance sheet for the restaurant businesses as the Spin-off Date and related to the sale of the Non-core Businesses; third party failures to achieve timely, effective Year 2000 remediation; and the potential inability to identify qualified franchisees to purchase Company restaurants at prices we consider appropriate under our strategy to reduce the percentage of system units we operate.
Industry risks and uncertainties include, but are not limited to, global and local business and economic and political conditions; legislation and governmental regulation; competition; success of operating initiatives and advertising and promotional efforts; volatility of commodity costs and increases in minimum wage and other operating costs; availability and cost of land and construction; adoption of new or changes in accounting policies and practices; consumer preferences, spending patterns and demographic trends; political or economic instability in local markets; and currency exchange rates.
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