American Express 2015 Annual Report Download - page 145

NOTE 14
DERIVATIVES AND HEDGING ACTIVITIES
The Company uses derivative financial instruments (derivatives) to manage exposures to various market risks. These
instruments derive their value from an underlying variable or multiple variables, including interest rates, foreign exchange
rates, and equity index or price, and are carried at fair value on the Consolidated Balance Sheets. 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 transact in derivatives for trading purposes.
Market risk is the risk to earnings or asset and liability values resulting from movements in market prices. The Company’s
market risk exposures include:
• Interest rate risk due to changes in the relationship between interest rates on the Company’s assets (such as loans,
receivables and investment securities) and interest rates on the Company’s liabilities (such as debt and deposits); and
• Foreign exchange risk related to earnings, funding, transactions and investments in currencies other than the U.S.
dollar.
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 primarily 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. As of December 31, 2015 and 2014, the Company did not have any designated cash flow hedges.
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 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
derivatives such as foreign exchange forwards and cross-currency swap contracts.
In addition to the exposures mentioned previously, 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, and counterparty risk exposures are centrally monitored.
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,
2015 and 2014 are subject to such master netting agreements with its derivative counterparties, and 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.
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