Capital One 2006 Annual Report Download - page 125

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generated by the transferred receivables, less the related net losses on the transferred receivables and interest expense related
to the securitization debt.
Note 23
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. 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. Credit risk is equal to the extent
of the fair value gain in a derivative, if the counterparty fails to perform. 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 Asset and Liability Committee, a
committee of Senior Management. 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.
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 and 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. In accordance with the Companys asset/liability
management policies, the Company reviews its risk profile on a monthly basis. The Companys Asset and 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 effects from movements in exchange rates.
The Company has also entered into interest rate swap agreements that modify the Companys exposure to interest rate risk by
effectively converting a portion of the Companys public fund certificates of deposit, senior notes, and U.S. Agency
investments from fixed rates to variable rates over the next ten years.
For the years ended December 31, 2006 and 2005, net gains or losses related to the ineffective portion of the Companys fair
value hedging instruments were not material.
Cash Flow Hedges
The Company has entered into interest rate swap agreements that effectively modify the Companys exposure to interest rate
risk by converting floating rate debt to a fixed rate over the next seven years. The agreements involve the receipt of floating
rate amounts in exchange for fixed rate interest payments over the life of the agreement without an exchange of underlying
principal amounts.