American Express 2010 Annual Report Download - page 51

Market Risk limits and escalation triggers within the Market
Risk Policy are approved by ALCO and by the ERMC. Market
risk is centrally monitored for compliance with policy and limits
by the Market Risk Committee, which reports into the ALCO
and is chaired by the Chief Market Risk Officer. Market risk
management is also guided by policies covering the use of
derivative financial instruments, funding and liquidity
and investments.
The Company’s market exposures are in large part by-
products of the delivery of its products and services. Interest
rate risk arises through the funding of cardmember receivables
and fixed-rate loans with variable-rate borrowings as well as
through the risk to net interest margin from changes in the
relationship between benchmark rates such as Prime
and LIBOR.
Interest rate exposure within the Company’s charge card and
fixed-rate lending products is managed by varying the
proportion of total funding provided by short-term and
variable-rate debt and deposits compared to fixed-rate debt
and deposits. In addition, interest rate swaps are used from
time to time to effectively convert fixed-rate debt to variable-
rate or to convert variable-rate debt to fixed-rate. The Company
may change the mix between variable-rate and fixed-rate
funding based on changes in business volumes and mix,
among other factors.
The Company does not engage in derivative financial
instruments for trading purposes. Refer to Note 12 to the
Consolidated Financial Statements for further discussion of
the Company’s derivative financial instruments.
The detrimental effect on the Company’s annual pretax
earnings of a hypothetical 100 basis point increase in interest
rates would be approximately $149 million ($97 million related
to the U.S. dollar), based on the 2010 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. As of year end 2010, the percentage of worldwide
charge card accounts receivable and loans that were deemed to
be fixed rate was 65 percent, or $63.7 billion, with the remaining
35 percent, or $34.3 billion, deemed to be variable rate.
The Company is also subject to market risk from changes in
the relationship between the benchmark Prime rate that
determines the yield on its variable-rate lending receivables
and the benchmark LIBOR rate that determines the effective
interest cost on a significant portion of its outstanding debt.
Differences in the rate of change of these two indices, commonly
referred to as basis risk, would impact the Company’s variable-
rate U.S. lending net interest margins because the Company
borrows at rates based on LIBOR but lends to its customers
based on the Prime rate. The detrimental effect on the
Company’s pretax earnings of a hypothetical 10 basis point
decrease in the spread between Prime and 1 month LIBOR
over the next 12 months is estimated to be $34 million. The
Company currently has approximately $34.3 billion of Prime-
based, variable-rate U.S. lending receivables that are funded
with LIBOR-indexed debt, including asset securitizations.
Foreign exchange risk is generated by cardmember cross-
currency charges, foreign subsidiary equity and foreign
currency earnings in units outside the United States. 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 and cross-currency swap contracts, which can help
“lock in” the value of the Company’s exposure to
specific currencies.
As of December 31, 2010 and 2009, foreign currency
derivative instruments with total notional amounts of
approximately $22 billion and $19 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 subsidiary equity 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, 2010.
With respect to earnings denominated in foreign currencies,
the adverse impact on pretax income of a hypothetical
10 percent strengthening of the U.S. dollar related to
anticipated overseas operating results for the next 12 months
would be approximately $152 million as of December 31, 2010.
With respect to translation exposure of foreign subsidiary
equity, including related foreign exchange forward contracts
outstanding, a hypothetical 10 percent strengthening in the
U.S. dollar would result in an immaterial reduction in equity
as of December 31, 2010.
The actual impact of interest rate and foreign exchange rate
changes will depend on, among other factors, the timing of rate
changes, the extent to which different rates do not move in the
same direction or in the same direction to the same degree, and
changes in the volume and mix of the Company’s businesses.
FUNDING & LIQUIDITY RISK MANAGEMENT
PROCESS
Liquidity risk is defined as the inability of the Company to meet
its ongoing financial and business obligations as they become
due at a reasonable cost. General principles and the overall
framework for managing liquidity risk across the Company
are defined in the Liquidity Risk Policy approved by the
ALCO and Audit and Risk Committee of the Board. Liquidity
risk is centrally managed by the Funding and Liquidity
Committee, which reports into the ALCO. The Company’s
liquidity objective is to maintain access to a diverse set of
cash, readily-marketable securities and contingent sources of
liquidity, such that the Company can continuously meet
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AMERICAN EXPRESS COMPANY
2010 FINANCIAL REVIEW