Prudential 2015 Annual Report Download - page 204

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
21. DERIVATIVE INSTRUMENTS
Types of Derivative Instruments and Derivative Strategies
Interest Rate Contracts
Interest rate swaps, options and futures are used by the Company to reduce risks from changes in interest rates, manage interest rate
exposures arising from mismatches between assets and liabilities (including duration mismatches) and to hedge against changes in the
value of assets it owns or anticipates acquiring or selling.
Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest rate swaps, the Company
agrees with counterparties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts
calculated by reference to an agreed upon notional principal amount.
The Company also uses swaptions, interest rate caps and interest rate floors to manage interest rate risk. A swaption is an option to
enter into a swap with a forward starting effective date. The Company pays a premium for purchased swaptions and receives a premium for
written swaptions. In an interest rate cap, the buyer receives payments at the end of each period in which the interest rate exceeds the
agreed strike price. Similarly, in an interest rate floor, the buyer receives payments at the end of each period in which the interest rate is
below the agreed strike price. Swaptions and interest rate caps and floors are included in interest rate options.
In exchange-traded interest rate futures transactions, the Company purchases or sells a specified number of contracts, the values of
which are determined by the values of underlying referenced investments, and posts variation margin on a daily basis in an amount equal to
the difference in the daily market values of those contracts. The Company enters into exchange-traded futures with regulated futures
commission’s merchants who are members of a trading exchange.
Equity Contracts
Equity index options are contracts which will settle in cash based on differentials in the underlying indices at the time of exercise and
the strike price. The Company uses combinations of purchases and sales of equity index options to hedge the effects of adverse changes in
equity indices within a predetermined range.
Total return swaps are contracts whereby the Company agrees with counterparties to exchange, at specified intervals, the difference
between the return on an asset (or market index) and LIBOR plus an associated funding spread based on a notional amount. The Company
generally uses total return swaps to hedge the effect of adverse changes in equity indices.
Foreign Exchange Contracts
Currency derivatives, including currency futures, options, forwards and 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 counterparties 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 investment 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 counterparties 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.
Credit Contracts
The Company writes credit default swaps for which it receives a premium to insure credit risk. These 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 these derivatives the Company sells credit protection on a single name reference, or certain index reference, and in
return receives a quarterly premium. This premium or credit spread generally corresponds to the difference between the yield on the
referenced names (or an index’s referenced 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 referenced amount of the contract to the counterparty 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 further discussion of guarantees. 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 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, and can provide a more liquid and cost effective
202 Prudential Financial, Inc. 2015 Annual Report