Prudential 2012 Annual Report Download - page 202

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
21. DERIVATIVE INSTRUMENTS (continued)
Foreign Exchange Contracts
Currency derivatives, including exchange-traded currency futures and options, currency forwards and currency swaps, are used by the
Company to reduce risks from changes in currency exchange rates with respect to investments denominated in foreign currencies that the
Company either holds or intends to acquire or sell, and to hedge the currency risk associated with net investments in foreign operations and
anticipated earnings of its foreign operations.
Under currency forwards, the Company agrees with other parties to deliver a specified amount of an identified currency at a specified
future date. Typically, the price is agreed upon at the time of the contract and payment for such a contract is made at the specified future
date. As noted above, the Company uses currency forwards to mitigate the impact of changes in currency exchange rates on U.S. dollar
equivalent earnings generated by certain of its non-U.S. businesses, primarily its international insurance and investments operations. The
Company executes forward sales of the hedged currency in exchange for U.S. dollars at a specified exchange rate. The maturities of these
forwards correspond with the future periods in which the non-U.S. dollar-denominated earnings are expected to be generated. These
earnings hedges do not qualify for hedge accounting.
Under currency swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between one currency
and another at an exchange rate and calculated by reference to an agreed principal amount. Generally, the principal amount of each currency
is exchanged at the beginning and termination of the currency swap by each party. These transactions are entered into pursuant to master
agreements that provide for a single net payment to be made by one counterparty for payments made in the same currency at each due date.
Credit Contracts
Credit derivatives are used by the Company to enhance the return on the Company’s investment portfolio by creating credit exposure
similar to an investment in public fixed maturity cash instruments. With credit derivatives the Company sells credit protection on an
identified name, or an index of names, and in return receives a quarterly premium. With credit default derivatives, this premium or credit
spread generally corresponds to the difference between the yield on the referenced name’s (or index reference names’) public fixed
maturity cash instruments and swap rates, at the time the agreement is executed. If there is an event of default by the referenced name or
one of the referenced names in the index, as defined by the agreement, then the Company is obligated to pay the counterparty the
referenced amount of the contract and receive in return the referenced defaulted security or similar security or (in the case of a credit
default index) pay the referenced amount less the auction recovery rate. See credit derivatives written section for discussion of guarantees
related to credit derivatives written. In addition to selling credit protection the Company has purchased credit protection using credit
derivatives in order to hedge specific credit exposures in the Company’s investment portfolio.
Other Contracts
TBAs. The Company uses “to be announced” (“TBA”) forward contracts to gain exposure to the investment risk and return of
mortgage-backed securities. TBA transactions can help the Company enhance the return on its investment portfolio. TBAs can provide a
more liquid and cost effective method of achieving these goals than purchasing or selling individual mortgage-backed pools. Typically, the
price is agreed upon at the time of the contract and payment for such a contract is made at a specified future date. Additionally, pursuant to
the Company’s mortgage dollar roll program, TBAs or mortgage-backed securities are transferred to counterparties with a corresponding
agreement to repurchase them at a future date. These transactions do not qualify as secured borrowings and are accounted for as
derivatives.
Loan Commitments. In its mortgage operations, the Company enters into commitments to fund commercial mortgage loans at
specified interest rates and other applicable terms within specified periods of time. These commitments are legally binding agreements to
extend credit to a counterparty. Loan commitments for loans that will be held for sale are recognized as derivatives and recorded at fair
value. The determination of the fair value of loan commitments accounted for as derivatives considers various factors including, among
others, terms of the related loan, the intended exit strategy for the loans based upon either securitization valuation models or investor
purchase commitments, prevailing interest rates, origination income or expense, and the value of service rights. Loan commitments that
relate to the origination of mortgage loans that will be held for investment are not accounted for as derivatives and accordingly are not
recognized in the Company’s financial statements. See Note 23 for a further discussion of these loan commitments.
Embedded Derivatives. The Company sells variable annuity products, which may include guaranteed benefit features that are
accounted for as embedded derivatives. These embedded derivatives are marked to market through “Realized investment gains (losses),
net” based on the change in value of the underlying contractual guarantees, which are determined using valuation models. The Company
maintains a portfolio of derivative instruments that is intended to economically hedge the risks related to the above products’ features. The
derivatives may include, but are not limited to equity options, total return swaps, interest rate swap options, caps, floors, and other
instruments. In addition, some variable annuity products feature an automatic rebalancing element, also referred to as an asset transfer
feature, to minimize risks inherent in the Company’s guarantees which reduces the need for derivatives.
The Company invests in fixed maturities that, in addition to a stated coupon, provide a return based upon the results of an underlying
portfolio of fixed income investments and related investment activity. The Company accounts for these investments as available-for-sale
fixed maturities containing embedded derivatives. Such embedded derivatives are marked to market through “Realized investment gains
(losses), net,” based upon the change in value of the underlying portfolio.
200 Prudential Financial, Inc. 2012 Annual Report