NOTES TO CONSOLIDATED FINANCIAL STATEMENTS KEYCORP AND SUBSIDIARIES A derivative that is designated and qualifies as a hedging instrument must be designated either a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. Key does not have any derivatives that hedge net investments in foreign operations. A fair value hedge is used to hedge changes in the fair value of existing assets, liabilities and firm commitments against changes in interest rates or other economic factors. Key recognizes the gain or loss on the derivative, as well as the related gain or loss on the hedged item underlying the hedged risk, in earnings during the period in which the fair value changes. Thus, if a hedge is perfectly effective, the change in the fair value of the hedged item will be offset, resulting in no net effect on earnings. A cash flow hedge is used to hedge the variability of future cash flows against changes in interest rates or other economic factors. The effective portion of a gain or loss on any cash flow hedge is reported as a component of “accumulated other comprehensive income (loss)” and reclassified into earnings in the same period or periods that the hedged transaction affects earnings. Any ineffective portion of the derivative gain or loss is recognized in earnings during the current period.  As a result of adopting SFAS No. 133, Key recorded cumulative after- tax losses of $1 million in earnings and $22 million in “accumulated other comprehensive income (loss)” as of January 1, 2001. The cumulative loss included in earnings represented the fair value at January 1, 2001, of all derivatives that were then designated as fair value hedges and the unrealized gain or loss on the related hedged assets and liabilities. The cumulative loss included in “accumulated other comprehensive income (loss)” represented the effective portion of the fair value of all derivatives designated as cash flow hedges. Key also uses derivatives for trading purposes. Key enters into contracts for such derivatives either to make a market for clients or for proprietary trading purposes. Derivatives used for trading purposes typically include financial futures, foreign exchange forward and spot contracts, written and purchased options (including currency options), and interest rate swaps, caps and floors. All derivatives used for trading purposes are recorded at fair value. Fair value is determined by estimating the present value of future cash flows. Derivatives with a positive fair value are included in “accrued DERIVATIVES USED FOR TRADING PURPOSES The model assumes that the estimated fair value of an option is amortized as compensation expense over the option’s vesting period. The pro forma effect of applying the fair value method of accounting to all forms of stock-based compensation (primarily stock options, restricted stock, discounted stock purchase plans and certain deferred compensation related awards) for the years ended December 31, 2003, 2002 and 2001, is shown in the following table and would, if recorded, have been included in “personnel expense” on the income statement. The Black-Scholes model requires several assumptions, which management developed and updates based on historical trends and current market observations. The level of accuracy achieved in deriving the estimated fair value of options is directly related to the accuracy of the underlying assumptions. The assumptions pertaining to options issued during 2003, 2002 and 2001, are shown in the following table . SFAS No. 123 requires companies like Key that have used the intrinsic value method to account for employee stock options to provide pro forma disclosures of the net income and earnings per share effect of accounting for stock options using the fair value method. Management estimates the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not a perfect indicator of the value of an employee stock option, but it is commonly used for this purpose. Effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123, “Accounting for Stock-Based Compensation.” Additional information pertaining to this accounting change is summarized under the heading “Accounting Pronouncements Adopted in 2003” on page 55. Through December 31, 2002, Key accounted for stock options issued to employees using the intrinsic value method outlined in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” This method requires that compensation expense be recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the grant date. Key’s employee stock options generally have fixed terms and exercise prices that are equal to or greater than the fair value of Key’s common shares at the grant date. As a result, Key generally had not recognized compensation expense related to stock options.  income and other assets” on the balance sheet, and derivatives with a negative fair value are included in “accrued expense and other liabilities.” Changes in fair value (including payments and receipts) are recorded in “investment banking and capital markets income” on the income statement. STOCK-BASED COMPENSATION PREVIOUS PAGE SEARCH BACK TO CONTENTS NEXT PAGE Year ended December 31, 2003 2002 2001 Average option life 5.0 years 4.1 years 3.9 years Future dividend yield 4.76% 4.84% 4.22% Share price volatility .280 .264 .330 Weighted-average risk-free interest rate 2.9% 3.9% 5.0% 54