Capital One 2001 Annual Report Download - page 63

Note O
Derivative Instruments and Hedging Activities
The Company maintains a risk management strategy that incorporates
the use of derivative instruments to minimize significant unplanned
fluctuations in earnings caused by interest rate and foreign exchange
rate volatility. The Company’s goal is to manage sensitivity to changes
in rates by modifying the repricing or maturity characteristics of
certain balance sheet assets and liabilities, thereby limiting the impact
on earnings. By using derivative instruments, the Company is exposed
to credit and market risk. If the counterparty fails to perform, credit
risk is equal to the extent of the fair value gain in a derivative. When
the fair value of a derivative contract is positive, this generally indicates
that the counterparty owes the Company, and, therefore, creates a
repayment risk for the Company. When the fair value of a derivative
contract is negative, the Company owes the counterparty, and
therefore, has no repayment risk. The Company minimizes the credit
(or repayment) risk in derivative instruments by entering into
transactions with high-quality counterparties that are reviewed
periodically by the Company’s credit committee. The Company also
maintains a policy of requiring that all derivative contracts be
governed by an International Swaps and Derivatives Association
Master Agreement; depending on the nature of the derivative
transaction, bilateral collateral agreements may be required as well.
Market risk is the adverse effect that a change in interest rates,
currency, or implied volatility rates has on the value of a financial
instrument. The Company manages the market risk associated with
interest rate and foreign exchange contracts by establishing and
monitoring limits as to the types and degree of risk that may be
undertaken.
The Company periodically uses interest rate swaps as part of its
interest rate risk management strategy. Interest rate swaps generally
involve the exchange of fixed and variable rate interest payments
between two parties, based on a common notional principal amount
and maturity date. As a result of interest rate fluctuations, hedged
assets and liabilities will appreciate or depreciate in market value. To
the extent that there is a high degree of correlation between the hedged
asset or liability and the derivative instrument, the income or loss
generated will generally offset the effect of this unrealized appreciation
or depreciation.
The Company’s foreign currency denominated assets and liabilities
expose it to foreign currency exchange risk. The Company enters into
various foreign exchange derivative contracts for managing foreign
currency exchange risk. Changes in the fair value of the derivative
instrument effectively offset the related foreign exchange gains or losses
on the items to which they are designated.
The Company has non-trading derivatives that do not qualify as
hedges. These derivatives are carried at fair value and changes in value
are included in current earnings.
The asset/liability management committee, as part of that committee’s
oversight of the Company’s asset/liability and treasury functions,
monitors the Company’s derivative activities. The Company’s
asset/liability management committee is responsible for approving
hedging strategies. The resulting strategies are then incorporated into
the Company’s overall interest rate risk management strategies.
Fair Value Hedges
The Company has entered into forward exchange contracts to hedge
foreign currency denominated investments against fluctuations in
exchange rates. The purpose of the Company’s foreign currency
hedging activities is to protect the Company from the risk of adverse
affects from movements in exchange rates.
During the year ended December 31, 2001, the Company recognized
substantially no net gains or losses related to the ineffective portions of
its fair value hedging instruments.
Cash Flow Hedges
The Company has entered into interest rate swap agreements for the
management of its interest rate risk exposure. The interest rate swap
agreements utilized by the Company effectively modify the Company’s
exposure to interest rate risk by converting floating rate debt to a fixed
rate over the next five years. The agreements involve the receipt of fixed
rate amounts in exchange for floating rate interest payments over the
life of the agreement without an exchange of underlying principal
amounts. The Company has also entered into interest rate swaps and
amortizing notional interest rate swaps to effectively reduce the interest
rate sensitivity of anticipated net cash flows of its interest-only strip
from securitization transactions over the next four years.
The Company has also entered into currency swaps that effectively
convert fixed rate foreign currency denominated interest receipts to
fixed dollar interest receipts on foreign currency denominated assets.
The purpose of these hedges is to protect against adverse movements
in exchange rates.
The Company has entered into forward exchange contracts to reduce
the Company’s sensitivity to foreign currency exchange rate changes
on its foreign currency denominated loans. The forward rate
agreements allow the Company to “lock-in” functional currency
equivalent cash flows associated with the foreign currency
denominated loans.
During the year ended December 31, 2001, the Company recognized
no net gains or losses related to the ineffective portions of its cash flow
hedging instruments. The Company recognized net losses of $5,138
during the year ended December 31, 2001, for cash flow hedges that
have been discontinued which have been included in interest income
in the income statement.
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