American Express 2001 Annual Report Download - page 35

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FINANCIAL REVIEW
borrowing requirements would be addressed through other means such as additional securitizations and sale or repurchase of
investment securities. This would result in higher interest expense on the company’s commercial paper and other debt, as well as
higher fees related to unused lines of credit. The company believes a two level downgrade is unlikely due to its capital position and
growth prospects.
The following sections include sensitivity analyses of three different types of market risk and estimate the effects of hypothetical
sudden and sustained changes in the applicable market conditions on the ensuing year’s earnings, based on year-end positions. The
market changes, assumed to occur as of year-end, are a 100 basis point increase in market interest rates, a 10 percent strengthen-
ing of the U.S. dollar versus all other currencies, and a 10 percent decline in the value of equity securities under management at
AEFA. Computations of the prospective effects of hypothetical interest rate, foreign exchange rate and equity market changes are
based on numerous assumptions,including relative levels of market interest rates, foreign exchange rates and equity prices, as well
as the levels of assets and liabilities. The hypothetical changes and assumptions will be different from what actually occurs in the
future. Furthermore, the computations do not incorporate actions that management could take if the hypothetical market changes
actually occur. As a result, actual earnings consequences will differ from those quantified below.
TRS’ hedging policies are established, maintained and monitored by the company’s treasury department. TRS generally manages
its exposures along product lines. A variety of interest rate and foreign exchange hedging strategies are employed to manage
interest rate and foreign currency risks.
TRS funds its Charge Card receivables and Cardmember loans using various funding sources, such as long- and short-term debt,
medium-term notes, commercial paper and asset securitizations. Cardmember receivables are predominantly funded by Credco
and its subsidiaries; funding for Cardmember loans is primarily through Centurion Bank. For its Charge Card and fixed rate lend-
ing products, interest rate exposure is managed through the issuance of long- and short-term debt and the use of interest rate swaps
and, to a lesser extent, caps. During 2001, TRS continued its strategy by augmenting its portfolio of interest rate swaps that con-
vert its domestic funding from floating rate to fixed rate. TRS regularly reviews its strategy and may modify it. For the majority of
its Cardmember loans, which are linked to a floating rate base and generally reprice each month, TRS uses floating rate funding.
The detrimental effect on TRS pretax earnings of a hypothetical 100 basis point increase in interest rates would be approximately
$48 million ($31 million related to the U.S. dollar) and $80 million ($61 million related to the U.S. dollar), based on 2001 and 2000
year-end positions, respectively. This effect is primarily a function of the extent of variable rate funding of Charge Card and fixed
rate lending products, to the degree that interest rate exposure is not managed by derivative financial instruments. With respect to
the managed portion of that interest rate exposure, a substantial amount of the $296 million of the company’s net after-tax unre-
alized losses recorded in other comprehensive income on the consolidated balance sheet at December 31, 2001 represents the fair
value of the related derivative financial instruments. These losses will be recognized in earnings during the terms of those deriva-
tives contracts at the same time that the company realizes the benefits of lower market rates of interest on its funding of Charge
Card and fixed rate lending products. Notwithstanding the unrealized losses, the company expects a year-over-year benefit from
lower interest rates in 2002 that is in excess of $400 million.
TRS’foreign exchange risk arising from cross-currency charges and balance sheet exposures is managed primarily by entering into
agreements to buy and sell currencies on a spot or forward basis. Additionally,in the latter parts of 2001 and 2000, foreign currency
forward sales (with notional amounts of $323 million and $386 million, respectively) and, in the latter part of 2000, foreign cur-
rency forward purchases (with notional amounts of $92 million) were contracted to manage a portion of anticipated cash flows
from operations in major overseas markets for the subsequent year. In early 2002, the company entered into additional forward
contracts covering a substantial portion of the remaining cash flows from operations.
Based on the year-end 2001 and 2000 foreign exchange positions, but excluding the forward contracts managing the anticipated
overseas operating results for the subsequent year, the effect on TRS’ earnings of a hypothetical 10 percent strengthening of the
U.S. dollar would be immaterial. With respect to the forward contracts related to anticipated overseas operating results for the sub-
sequent year, a 10 percent strengthening would create hypothetical pretax gains of $29 million and $27 million related to the 2001
and 2000 year-end positions, respectively. Such gains,if any, would mitigate the negative effect of a stronger U.S. dollar on overseas
earnings for the subsequent year.