American Express 2014 Annual Report Download - page 100

AMERICAN EXPRESS COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 14
DERIVATIVES AND HEDGING ACTIVITIES
The Company uses derivative financial instruments (derivatives) to manage exposures to various market risks. Derivatives derive their value
from an underlying variable or multiple variables, including interest rate, foreign exchange, and equity index or price. 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 management. The Company does not engage in derivatives for trading purposes.
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:
폷Interest rate risk in its card, insurance and Travelers Cheque and other prepaid products businesses, as well as its investment portfolios; and
폷Foreign exchange risk in its operations outside the U.S. and the associated funding of such operations.
The Company centrally monitors market risks using market risk limits and escalation triggers as defined in its Asset/Liability Management
Policy.
The Company’s market exposures are in large part byproducts of the delivery of its products and services. Interest rate risk arises through
the funding of Card Member 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 economically convert fixed-rate debt obligations to variable-rate obligations or to convert variable-rate debt
obligations to fixed-rate obligations. The Company may change the mix between variable-rate and fixed-rate funding based on changes in
business volumes and mix, among other factors.
Foreign exchange risk is generated by Card Member cross-currency charges, foreign currency balance sheet exposures, foreign subsidiary
equity and foreign currency earnings in entities outside the U.S. 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 derivatives such as foreign exchange forwards and cross-currency swap contracts, which can help
mitigate the Company’s exposure to specific currencies.
In addition to the exposures identified above, effective August 1, 2011, the Company entered into a total return contract (TRC) to hedge
its exposure to changes in the fair value of its equity investment in ICBC in local currency. Under the terms of the TRC, the Company
received from the TRC counterparty an amount equivalent to any reduction in the fair value of its investment in ICBC in local currency, and
the Company paid to the TRC counterparty an amount equivalent to any increase in the fair value of its investment in local currency, along
with all dividends paid by ICBC, as well as ongoing hedge costs. The TRC was fully unwound on July 18, 2014 upon the sale of the remaining
underlying ICBC shares.
Derivatives may give rise to counterparty credit risk, which is the risk that a derivative counterparty will default on, or otherwise be
unable to perform pursuant to, an uncollateralized derivative exposure. The Company manages this risk by considering the current exposure,
which is the replacement cost of contracts on the measurement date, as well as estimating the maximum potential value of the contracts over
the next 12 months, considering such factors as the volatility of the underlying or reference index. To mitigate derivative credit risk,
counterparties are required to be pre-approved by the Company and rated as investment grade. Counterparty risk exposures are centrally
monitored by the Company. Additionally, in order to mitigate the bilateral counterparty credit risk associated with derivatives, the Company
has in certain instances entered into master netting agreements with its derivative counterparties, which provide a right of offset for certain
exposures between the parties. A majority of the Company’s derivative assets and liabilities as of December 31, 2014 and 2013 is subject to
such master netting agreements with its derivative counterparties. There are no instances in which management makes an accounting policy
election to not net assets and liabilities subject to an enforceable master netting agreement on the Company’s Consolidated Balance Sheets.
To further mitigate bilateral counterparty credit risk, the Company exercises its rights under executed credit support agreements with certain
of its derivative counterparties. These agreements require that, in the event the fair value change in the net derivatives position between the
two parties exceeds certain dollar thresholds, the party in the net liability position posts collateral to its counterparty. All derivative contracts
cleared through a central clearinghouse are collateralized to the full amount of the fair value of the contracts.
In relation to the Company’s credit risk, under the terms of the derivative agreements it has with its various counterparties, the Company
is not required to either immediately settle any outstanding liability balances or post collateral upon the occurrence of a specified credit risk-
related event. Based on the assessment of credit risk of the Company’s derivative counterparties as of December 31, 2014 and 2013, the
Company does not have derivative positions that warrant credit valuation adjustments.
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