American Express 2007 Annual Report Download - page 53

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2007 FINANCIAL REVIEW
AMERICAN EXPRESS COMPANY
MARKET RISK MANAGEMENT PROCESS
Market risk is the risk to earnings or value resulting from
movements in market prices. The Company’s market risk
exposure is primarily generated by:
•฀Interest rate risk in its card, insurance, and certificate
businesses; and
•฀Foreign exchange risk in its international operations.
General principles and the overall framework for managing
market risk across the Company are defined in the Market Risk
Policy approved by the ERMC. Market risk is centrally managed
by the Market Risk Committee, chaired by the Chief Market
Risk Officer of the Company. Within each business, market
risk exposures are monitored and managed by various asset/
liability committees, guided by Board-approved policies covering
derivative financial instruments, funding and investments.
Derivative financial instruments derive their value from an
underlying variable or multiple variables, including interest rate,
foreign exchange, and equity indices or prices. These instruments
enable end users to increase, reduce or alter exposure to various
market risks and, for that reason, are an integral component of the
Company’s market risk and related asset/liability management
strategy and processes. Use of derivative financial instruments is
incorporated into the discussion below as well as Note 12 to the
Consolidated Financial Statements.
Market exposure is a byproduct of the delivery of products
and services to cardmembers. Interest rate risk is primarily
generated by funding cardmember charges and fixed-rate
loans with variable rate borrowings. These 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’s strategy is to lengthen the maturity of interest rate
hedges in periods of low interest rates and to shorten their
maturity in periods of high interest rates. Based on the expected
2008 debt funding requirements for worldwide charge card and
fixed rate lending receivables, approximately 29 percent have been
funded with fixed rate debt or hedged as of December 31, 2007.
The Company may change the amount hedged and the hedge
percentage may change based on changes in business volumes
and mix, among other factors. 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 $18
billion and $11 billion were outstanding at December 31, 2007
and 2006, respectively. These derivatives generally qualify for
hedge accounting. A portion of these derivatives outstanding as
of December 31, 2007, extend to 2017.
The detrimental effect on the Company’s pretax earnings of
a hypothetical 100 basis point increase in interest rates would
be approximately $227 million ($205 million related to the
U.S. dollar), based on the 2007 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
value of the Company’s exposure to specific currencies.
At December 31, 2007 and 2006, foreign currency products
with total notional amounts of approximately $15 billion
and $10 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, 2007. 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
12 months, including any related foreign exchange forward
contracts entered into in January 2008, would hypothetically
be $115 million as of December 31, 2007. 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, 2007.
LIQUIDITY RISK MANAGEMENT PROCESS
Liquidity risk is defined as the inability to access cash and
equivalents needed to meet business requirements and satisfy
the Company’s obligations. General principles and the overall
framework for managing liquidity risk across the Company are
defined in the Liquidity Risk Policy approved by the ERMC.
The Company balances the trade-offs between maintaining too
much liquidity, which can be costly and limit financial flexibility,
with having inadequate liquidity, which may result in financial
distress during a liquidity event. Liquidity risk is centrally
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