Discover 2009 Annual Report Download - page 97

Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, correlations or
other market factors will result in losses for a position or portfolio. We are exposed to market risk primarily from changes
in interest rates.
Interest Rate Risk. Changes in interest rates impact interest-earning assets, principally managed loan receivables.
Changes in interest rates also impact interest sensitive liabilities that finance these assets, including asset-backed
securitizations, deposits, and short-term and long-term borrowings.
Our interest rate risk management policies are designed to measure and manage the potential volatility of earnings
that may arise from changes in interest rates by having a financing portfolio that reflects the existing repricing schedules
of credit card loan receivables. To the extent that asset and related financing repricing characteristics of a particular
portfolio are not matched effectively, we may utilize interest rate derivative contracts, such as swap agreements, to
achieve our objectives. Interest rate swap agreements effectively convert the underlying asset or financing from fixed to
floating rate or from floating to fixed rate.
We use an interest rate sensitivity simulation to assess our interest rate risk exposure. For purposes of presenting the possible
earnings effect of a hypothetical, adverse change in interest rates over the 12-month period from our reporting date, we
assume that all interest rate sensitive assets and liabilities will be impacted by a hypothetical, immediate 100 basis point
increase in interest rates as of the beginning of the period. The sensitivity is based upon the hypothetical assumption that all
relevant types of interest rates that affect our results would increase instantaneously, simultaneously and to the same degree.
Our interest rate sensitive assets include certain loan receivables, certain amounts due from asset securitizations,
interest-earning deposits and certain investment securities. Although we have moved the majority of our credit card loans
to variable rates, some of our loans are still at fixed rates. Due to new credit card legislation, we have restrictions on our
ability to mitigate interest rate risk by adjusting rates on existing balances. Assets with rates that are fixed at period end
but which will mature, or otherwise contractually reset to a market-based indexed rate or other fixed rate prior to the end
of the 12-month period, are considered to be rate sensitive. The latter category includes certain credit card loans that may
be offered at below-market rates for an introductory period, such as balance transfers and special promotional programs,
after which the loans will contractually reprice in accordance with our normal market-based pricing structure. For
purposes of measuring rate sensitivity for such loans, only the effect of the hypothetical 100 basis point change in the
underlying market-based indexed rate or other fixed rate has been considered rather than the full change in the rate to
which the loan would contractually reprice. For assets that have a fixed interest rate at the fiscal period end but which
contractually will, or are assumed to, reset to a market-based indexed rate or other fixed rate during the next 12 months,
earnings sensitivity is measured from the expected repricing date. In addition, for all interest rate sensitive assets,
earnings sensitivity is calculated net of expected loan losses.
Interest rate sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for
the next 12-month period. Thus, liabilities that vary with changes in a market-based index, such as Federal Funds or
LIBOR, which will reset before the end of the 12-month period, or liabilities whose rates are fixed at the fiscal period end
but which will mature and are assumed to be replaced with a market-based indexed rate prior to the end of the 12-month
period, also are considered to be rate sensitive. For these fixed rate liabilities, earnings sensitivity is measured from the
expected repricing date.
Assuming an immediate 100 basis point increase in the interest rates affecting all interest rate sensitive assets and
liabilities at November 30, 2009, we estimate that the pretax income (reported on a managed basis) over the following
12-month period would be increased by approximately $84 million. Assuming an immediate 100 basis point increase in
the interest rates affecting all interest rate sensitive assets and liabilities at November 30, 2008, we estimated that the
pretax income (reported on a managed basis) over the following 12-month period would be decreased by approximately
$38 million. At November 30, 2009, a majority of our credit card loan receivables have moved to variable rates, which
will have a positive impact on pretax income in a rising interest-rate scenario. We have not provided an estimate of any
impact on pretax income of a decrease in interest rates as many of our interest rate sensitive assets and liabilities are tied
to interest rates that are already at or near their minimum levels and, therefore, could not materially decrease further.
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