American Express 2006 Annual Report Download - page 54

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2006 fi nancial review
american express company
assets and liabilities generally do not create naturally
offsetting positions with respect to basis, re-pricing, or
maturity characteristics.
For the Company’s charge card and fixed-rate
lending products, interest rate exposure is managed by
shifting the mix of funding toward fixed-rate debt and
by using derivative instruments, with an emphasis on
interest rate swaps, which effectively fix interest expense
for the length of the swap. The Company endeavors
to lengthen the maturity of interest rate hedges in
periods of low or falling interest rates and to shorten
their maturity in periods of high or 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 $10 billion and $22 billion
were outstanding at December 31, 2006 and 2005,
respectively. These derivatives generally qualify for hedge
accounting. A portion of these derivatives outstanding as
of December 31, 2006, 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 $263 million
($250 million related to the U.S. dollar), based on the
2006 year-end positions. This effect, which is calculated
using a static asset liability gapping model, is primarily
determined by the volume of variable rate funding of
charge card and fixed-rate lending products for which
the interest rate exposure is not managed by derivative
financial instruments.
Foreign exchange risk is generated by cardmember
cross-currency charges, foreign currency denominated
balance sheet exposures, translation exposure of foreign
operations, and foreign currency earnings in international
units. The Company’s foreign exchange risk is managed
primarily by entering into agreements to buy and sell
currencies on a spot basis or by hedging 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, options,
and cross-currency swap contracts, which can help “lock
in” the Company’s exposure to specific currencies.
At December 31, 2006 and 2005, foreign currency
products with total notional amounts of approximately
$48 billion and $30 billion, respectively, were
outstanding. Derivative hedging activities related to
cross-currency charges, balance sheet exposures, and
foreign currency earnings generally do not qualify for
hedge accounting; however, derivative hedging activities
related to translation exposure of foreign operations
generally do.
With respect to cross-currency charges and balance
sheet exposures, including related foreign exchange
forward contracts outstanding, the effect on the
Company’s earnings of a hypothetical 10 percent change
in the value of the U.S. dollar would be immaterial as of
December 31, 2006. With respect to foreign currency
earnings, the adverse impact on pretax income of a
10 percent strengthening of the U.S. dollar related
to anticipated overseas operating results for the next
twelve months, including any related foreign exchange
option contracts entered into in January 2007, would
hypothetically be $71 million as of December 31, 2006.
With respect to translation exposure of foreign
operations, including related foreign exchange forward
contracts outstanding, a 10 percent strengthening in the
U.S. dollar would result in an immaterial reduction in
equity as of December 31, 2006.
In conjunction with its international banking
operations, the Company uses derivative financial
instruments to manage market risk related to specific
interest rate, foreign exchange and price risk exposures
arising from deposits, loans and debt and equity
securities holdings, and limited trading positions. At
December 31, 2006 and 2005, interest rate products
related to trading and non-trading positions with notional
amounts totaling approximately $29 billion and $17
b i l l i o n , r e s p e c t i v e l y, w e r e o u t s t a n d i n g . A d d i t i o n a l l y , e q u i t y
products related to trading and non-trading positions
with notional amounts of $533 million and $740 million,
respectively, were outstanding at December 31, 2006
and 2005. These derivatives generally do not qualify
for hedge accounting.
As noted, market risk arises from the international
banking trading activities in foreign exchange (both
directly through daily exchange transactions as well
as through foreign exchange derivatives), interest rate
derivatives (primarily swaps), equity derivatives and
securities trading. Proprietary positions taken in foreign
exchange instruments, interest rate risk instruments
and the securities portfolios are monitored daily against
Value-at-Risk (VaR) limits. The VaR methodology the
Company uses to measure the daily exposure from trading
activities is calculated using a parametric technique with
a correlation matrix based upon historical data. The
VaR measure uses a 99 percent confidence interval to
estimate potential trading losses over a one-day period.
The average VaR for trading activities was less than
$1 million for both 2006 and 2005.