American Express 2005 Annual Report Download - page 46

Additionally, a specific airline risk group was created in
order to ensure these institutional relationships, which
have become a key component of the Company’s spend-
centric business model, are appropriately assessed as to
their risk.
Market Risk Management Process
Market risk represents the loss in value of portfolios and
financial instruments due to adverse changes in market
variables. The Company’s non-trading related market
risk consists of:
®Interest rate risk in its card, insurance and certificate
businesses; and
®Foreign exchange risk in its international operations.
Market risk is centrally managed by the corporate trea-
surer who also acts as the Vice Chairman of the ERMC.
Within each business, market risk exposures are moni-
tored and managed by various asset liability committees
within the parameters of Board-approved policies cover-
ing derivative financial instruments, funding and invest-
ments. With respect to derivative financial instruments,
the value of such instruments is derived from an under-
lying variable or multiple variables, including commod-
ity, equity, foreign exchange and interest rate indices or
prices. These instruments enable the end users to
increase, reduce or alter exposure to various market risks
and, as such, are an integral component of the Company’s
market risk and related asset liability management strat-
egy and processes. Use of derivative financial instruments
is incorporated into the discussion below as well as
Note 10 to the Consolidated Financial Statements.
Market exposure is a byproduct of the delivery of prod-
ucts and services to cardmembers. Interest rate risk is
generated by funding cardmember charges and fixed
rate loans with variable rate borrowings. Such assets and
liabilities generally do not create naturally offsetting
positions as it relates to basis, re-pricing, or maturity
characteristics. By using derivative financial instru-
ments, such as interest rate swaps, the interest rate pro-
file can be adjusted to maintain and manage a desired
profile. A portion of interest rate risk exposure usually
remains unhedged, to enable the Company to take a
view on interest rate changes. In addition, foreign
exchange risk is generated by cardmember cross-
currency charges, foreign currency denominated
balance sheet exposures and foreign currency earnings
in international units. The Company hedges this market
exposure to the extent it is economically justified
through various means including the use of derivative
financial instruments, such as foreign exchange forward
and cross-currency swap contracts, which can help
“lock in” the Company’s exposure to specific currencies
at a specified rate. As a general matter, virtually all
foreign exchange risk arising from cardmember cross-
currency charges, foreign currency balance sheet
exposures and foreign currency earnings is risk man-
aged to reduce the Company’s exposure to currency rate
fluctuations.
For the Company’s charge card and fixed rate lending
products interest rate exposure is managed through a
combination of shifting the mix of funding toward
fixed rate debt and through the use of derivative
instruments, with an emphasis on interest rate swaps,
that effectively fix interest expense for the length of the
swap. The Company endeavors to lengthen the maturity
of interest rate hedges in periods of falling interest rates
and to shorten their maturity in periods of rising interest
rates. For the majority of its cardmember loans, which
are linked to a floating rate base and generally reprice
each month, the Company uses floating rate funding.
The Company regularly reviews its strategy and may
modify it. Non-trading interest rate derivative financial
instruments, primarily interest rate swaps, with notional
amounts of approximately $22 billion and $38 billion
were outstanding at December 31, 2005 and 2004,
respectively. These derivatives generally qualify for
hedge accounting. A portion of these derivatives out-
standing as of December 31, 2005 extend to 2015.
The detrimental effect on the Company’s pretax earnings
of a hypothetical 100 basis point increase in interest
rates would be approximately $180 million ($158 mil-
lion related to the U.S. dollar), based on the 2005
year-end positions. This effect, which is calculated using
a static asset liability gapping model to quantify the
impact of a 100 basis point shift, 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.
The Company’s foreign exchange risk arising from
cross-currency charges and balance sheet exposures, for-
eign currency earnings and translation exposure of for-
eign operations is managed primarily by entering into
agreements to buy and sell currencies on a spot or for-
ward basis as well as foreign currency options. At Decem-
ber 31, 2005 and 2004, foreign currency products with
total notional amounts of approximately $30 billion and
$37 billion, respectively were outstanding. Derivative
hedging activities related to cross-currency charges,
Financial Review
AXP / AR.2005
[44 ]