NOTE 7 - Derivative and Other Off-Balance Sheet Financial Instruments
The company uses derivative financial instruments for nontrading purposes to manage its exposure to interest and foreign exchange rates, financial indices and its funding costs. In addition, American Express Bank (AEB) enters into derivative contracts both to meet the needs of its clients and, to a limited extent, for proprietary trading purposes.
There are a number of risks associated with derivatives.
Market risk is the possibility that the value of the
derivative financial instrument will change. The company
is not exposed to market risk related to derivatives
held for nontrading purposes beyond that inherent in
cash market transactions. AEB is generally not subject
to market risk when it enters into a contract with a
client, as it usually enters into an offsetting contract or
uses the position to offset an existing exposure. AEB
takes proprietary positions within approved limits.
These positions are monitored daily at the local and
headquarters levels against Value at Risk (VAR) limits.
The company does not enter into derivative contracts
with features that would leverage or multiply its market
risk.
Credit risk related to derivatives and other off-balance
sheet financial instruments is the possibility that the
counterparty will not fulfill the terms of the contract. It
is monitored through established approval procedures,
including setting concentration limits by counterparty
and country, reviewing credit ratings and requiring collateral
where appropriate. For its trading activities with
clients, AEB requires collateral when it is not willing to
assume credit exposure to counterparties for either contract
mark-to-market or delivery risk. A significant
portion of the company’s transactions are with counterparties
rated A or better by nationally recognized
credit rating agencies. The company also uses master
netting agreements which allow the company to settle
multiple contracts with a single counterparty in one
net receipt or payment in the event of counterparty
default. Credit risk approximates the fair value of contracts
in a gain position (asset) and totaled $0.7 billion
and $0.8 billion at December 31, 1999 and 1998,
respectively. The fair value represents the replacement
cost and is determined by market values, dealer quotes
or pricing models.
The following tables detail information regarding the
company’s derivatives at December 31:
* These are predominantly contracts with clients and the related hedges of those client contracts. The company’s net trading foreign currency exposure was approximately $93 million and $24 million at December 31, 1999 and 1998, respectively.
The average aggregate fair values of derivative financial instruments held for trading purposes were computed based on monthly information. Net derivative trading gains of $83 million and $137 million for 1999 and 1998, respectively, were primarily due to trading in foreign currency forward contracts and are included in Other Commissions and Fees.
INTEREST RATE PRODUCTS
The company uses interest rate products, principally swaps, primarily to manage funding costs related to Travel Related Services’ (TRS) Charge Card and Cardmember lending businesses. For its Charge Card and fixed rate lending products, TRS uses interest rate swaps to achieve a targeted mix of fixed and floating rate funding. For the majority of its Cardmember loans, which are linked to a floating rate base and generally reprice each month, TRS generally enters into interest rate swaps, to the extent necessary, paying rates that reprice similarly with changes in the base rate of the underlying loans.
AEB uses interest rate products to manage its portfolio of loans, deposits and securities holdings. The termination dates of nontrading interest rate swaps are generally matched with the maturity dates of the underlying assets and liabilities.
For interest rate swaps that are used for nontrading purposes and meet the criteria for hedge accounting, interest is accrued and reported in Other Receivables and Interest and Dividends or Accounts Payable and Interest Expense, as appropriate. Products used for trading purposes are reported at fair value in Other Assets or Other Liabilities, as appropriate, with unrealized gains and losses recognized currently in Other Revenues.
AEFA uses interest rate caps, swaps and floors to protect the margin between the interest rates earned on investments and the interest rates credited to holders of investment certificates and fixed annuities. Interest rate caps, swaps and floors generally mature within five years. The costs of interest rate caps and floors are reported in Other Assets and amortized into Interest and Dividends on a straight-line basis over the term of the contract; benefits are recognized in income when earned.
In 1998, AEFA entered into interest rate swaps to manage the level of 1999 fee income earned on the management of fixed income securities in variable annuities and mutual funds. These swaps are used for nontrading purposes and meet the criteria for hedge accounting. Interest is accrued and reported in Other Receivables or Accounts Payable, as appropriate, and Management and Distribution Fees.
See Note 4 for further information regarding the company’s use of interest rate products related to short- and long-term debt obligations.
FOREIGN CURRENCY PRODUCTS
The company uses foreign currency products primarily to hedge net investments in foreign operations and to manage transactions denominated in foreign currencies. In addition, AEB enters into derivative contracts both to meet the needs of its clients and, to a limited extent, for trading purposes, including taking proprietary positions.
Foreign currency exposures are hedged, where practical and economical, through foreign currency contracts. Foreign currency contracts involve the purchase and sale of a designated currency at an agreed upon rate for settlement on a specified date. Foreign currency forward contracts generally mature within one year, whereas foreign currency spot contracts generally settle within two days.
For foreign currency products used to hedge net investments in foreign operations, unrealized gains and losses as well as related premiums and discounts are reported in Shareholders’ Equity. For foreign currency contracts related to transactions denominated in foreign currencies, unrealized gains and losses are reported in Other Assets and Other Commissions and Fees or Other Liabilities and Other Expenses, as appropriate. Related premiums and discounts are reported in Other Assets or Other Liabilities, as appropriate, and amortized into Interest Expense and Other Expenses over the term of the contract. Foreign currency products used for trading purposes are reported at fair value in Other Assets or Other Liabilities, as appropriate, with unrealized gains and losses recognized currently in Other Commissions and Fees.
The company also uses foreign currency forward contracts to hedge its firm commitments. In addition, for selected major overseas markets, the company uses foreign currency forward contracts to hedge future income, generally for periods not exceeding one year; unrealized gains and losses are recognized currently in income. In the latter part of 1999 and 1998, foreign currency forward contracts were both sold (with notional amounts of $611 million and $569 million, respectively) and purchased (with notional amounts of $25 million and $34 million, respectively) to manage a majority of anticipated future cash flows in major overseas markets. The impact of these activities was not material.
OTHER PRODUCTS
Included in Other Products are purchased and written index options used by AEFA to hedge against adverse changes in the U.S. equities markets, which affect revenues earned on assets under management. Index options are carried at market value and included in Other Assets or Other Liabilities, as appropriate. Gains and losses on these options are deferred until the related revenues are earned. At December 31, 1998, the notional value of these options was $1.2 billion.
Other Products also include written and purchased index options used by AEFA to manage the margin related to certain investment certificate and annuity products that pay interest based upon the relative change in a major stock market index between the beginning and end of the product’s term. Purchased and written options used in conjunction with these products are reported in Other Assets and Other Liabilities, respectively. The amortization of the cost of purchased options and the proceeds of written options, along with changes in intrinsic value of the contracts, are included in Interest and Dividends. At December 31, 1999 and 1998, the notional value of these options was $1.6 billion and $1.1 billion, respectively.
OTHER OFF-BALANCE SHEET FINANCIAL INSTRUMENTS
The company’s other off-balance sheet financial instruments principally relate to extending credit to satisfy the needs of its clients. The contractual amount of these instruments represents the maximum potential credit risk, assuming the contract amount is fully utilized, the counterparty defaults and collateral held is worthless. Management does not expect any material adverse consequence to the company’s financial position to result from these contracts.
The company is committed to extend credit to certain Cardmembers as part of established lending product agreements. Many of these are not expected to be drawn; therefore, total unused credit available to Cardmembers does not represent future cash requirements. The company’s Charge Card products have no preset spending limit and are not reflected in unused credit available to Cardmembers.
The company may require collateral to support its loan commitments based on the creditworthiness of the borrower.
Standby letters of credit and guarantees primarily represent conditional commitments to insure the performance of the company’s customers to third parties. These commitments generally expire within one year.
The company issues commercial and other letters of credit to facilitate the short-term trade-related needs of its clients, which typically mature within six months. At December 31, 1999 and 1998, the company held $1,023 million and $829 million, respectively, of collateral supporting standby letters of credit and guarantees and $220 million and $215 million, respectively, of collateral supporting commercial and other letters of credit.
Other financial institutions have committed to extend lines of credit to the company of $11.5 billion and $10.3 billion at December 31, 1999 and 1998, respectively.
