American Express 1998 Annual Report Download - page 33

Based on the year-end 1998 and 1997 foreign
exchange positions, but excluding the forward contracts
managing the anticipated overseas cash flows for the subse-
quent year, the effect on TRS’ earnings of the hypothetical
10% strengthening of the U.S. dollar would be immaterial.
With respect to the forward contracts related to anticipated
cash flows for the subsequent year, the 10% strengthening
would create a hypothetical pretax gain of $54 million and
$41 million related to the 1998 and 1997 year-end posi-
tions, respectively. Such gains, if any, would mitigate the
negative impact that a strengthening U.S. dollar would
have on overseas earnings for the subsequent year.
AEFA’s owned investment securities are, for the most
part, held by its life insurance and investment certificate
subsidiaries, which primarily invest in long-term and inter-
mediate-term fixed income securities to provide their clients
with a competitive rate of return on their investments while
minimizing risk. Investment in fixed income securities pro-
vides AEFA with a dependable and targeted margin between
the interest rate earned on investments and the interest rate
credited to clients’ accounts. AEFA does not invest in secu-
rities to generate trading profits for its own account.
AEFA’s life insurance and investment certificate sub-
sidiaries’ investment committees meet regularly to review
models projecting different interest rate scenarios and their
impact on the profitability of each subsidiary. The commit-
tees’ objective is to structure their investment security
portfolios based upon the type and behavior of the prod-
ucts in the liability portfolios, to achieve targeted levels of
profitability and meet contractual obligations.
Rates credited to customers’ accounts are generally reset
at shorter intervals than the maturity of underlying invest-
ments. Therefore, AEFA’s margins may be impacted by
changes in the general level of interest rates. Part of the com-
mittees’ strategies include the purchase of derivatives, such
as interest rate caps, swaps and floors, for hedging purposes.
AEFA’s fees earned on the management of fixed income
securities in variable annuities and mutual funds are gener-
ally based on the value of the portfolios. To manage the level
of 1999 fee income, AEFA has entered into a series of swaps
designed to mitigate the negative effect on fees that would
result from an increase in interest rates.
The negative effect on AEFA’s pretax earnings of a
100 basis point increase in interest rates, which assumes
repricings and customer behavior based on the application of
proprietary models to the book of business at December 31,
1998 and 1997, would be approximately $55 million and
$40 million for 1998 and 1997, respectively.
AEFA’s fees earned on the management of equity secu-
rities in variable annuities and mutual funds are generally
based on the value of the portfolios. To manage the level of
fee income in the subsequent year, AEFA has entered into
a series of stock index option transactions designed to mit-
igate, for a substantial portion of the portfolios, the negative
effect on fees that would result from a decline in the equity
markets. The negative effect on AEFA’s pretax earnings of
the 10% decline in equity markets discussed above would
be approximately $72 million and $20 million based on
assets under management and the index options as of
December 31, 1998 and 1997, respectively.
AEB/TC employs a variety of on- and off-balance
sheet financial instruments in managing its exposure to
fluctuations in interest and currency rates. Derivative instru-
ments consist principally of foreign exchange spot and
forward contracts, interest rate swaps, foreign currency
options and forward rate agreements. Generally, they are used
to manage specific on-balance sheet interest rate and foreign
exchange exposures related to deposits and long-term debt,
equity, loans and securities holdings.
The negative effect of the 100 basis point increase in
interest rates on AEB/TC’s pretax earnings would be negli-
gible as of December 31, 1998 and 1997. The impact on
earnings of the 10% strengthening of the U.S. dollar
described above would be negligible and, with respect to
translation exposure of foreign operations, would result in a
$14 million pretax charge against equity as of December 31,
1998 and 1997.
AEB utilizes foreign exchange and interest rate prod-
ucts to meet the needs of its customers. Customer positions
are usually, but not always, offset. They are evaluated in
terms of AEB’s overall interest rate or foreign exchange
exposure. AEB also takes limited proprietary positions.
Potential daily exposure from trading activities is calculated
using a Value at Risk methodology. This model employs a
parametric technique using a correlation matrix based on
historical data. The Value at Risk measure uses a 99%
confidence interval to estimate potential trading losses over
a one day period. During 1998 and at December 31, 1997,
the Value at Risk for AEB was less than $3 million.
Asset/liability and market risk management at AEB
are supervised by the Asset and Liability Committee. This
committee comprises senior business managers and the
Chairman of AEB. The committee meets monthly and
monitors (a) liquidity, (b) capital levels, (c) market risk
and (d) investment portfolios. The committee evaluates
current market conditions and determines AEB’s tactics
within risk limits approved by AEB’s Board of Directors.
AEB’s treasury, risk management and global trading man-
agement issue policies and control procedures and
delegate risk limits throughout AEB’s regional trading
centers.
AEB’s overall credit policies are approved by the
Finance and Credit Policy Committee of AEB’s Board of
Directors. Credit lines are based on a tiered approval lad-
der, with levels of authority delegated to each country,
geographic area, AEB’s senior management, and AEB’s
Board of Directors. Approval authorities are based on fac-
tors such as type of borrower, nature of transaction,
collateral, and overall risk rating. AEB controls the credit
risk arising from derivative transactions through the same
procedures. The Credit Audit department reviews all
significant exposures periodically. Risk of all foreign
exchange and derivative transactions is reviewed by AEB
on a regular basis.
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