Sears 2006 Annual Report Download - page 53

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Company faces market risk exposure in the form of interest rate risk, foreign currency risk and equity
price risk. These market risks arise from the Company’s derivative financial instruments and debt obligations.
Interest Rate Risk
The Company manages interest rate risk through the use of fixed and variable-rate funding and interest rate
derivatives. As of February 3, 2007, the Company had interest rate derivatives with a notional amount of
$120 million, nominal fair value and a weighted average remaining life of 0.8 years. All debt securities and
interest-rate derivative instruments are considered non-trading. As of February 3, 2007, 13% of the Company’s
debt portfolio was variable rate. Based on the size of this variable rate debt portfolio at February 3, 2007, which
totaled approximately $448 million, an immediate 100 basis point change in interest rates would have affected
annual pretax funding costs by $4.5 million. These estimates do not take into account the effect on income
resulting from invested cash or the returns on assets being funded. These estimates also assume that the variable
rate funding portfolio remains constant for an annual period and that the interest rate change occurs at the
beginning of the period.
Foreign Currency Risk
As of February 3, 2007, the Company had a series of foreign currency forward contracts outstanding,
totaling $400 million Canadian notional value and with a weighted average remaining life of 0.4 years, designed
to hedge the Company’s net investment in Sears Canada against adverse changes in exchange rates. The
aggregate fair value of the forward contracts as of February 3, 2007 was $26 million. A hypothetical 10%
adverse movement in the level of the Canadian exchange rate relative to the U.S. dollar as of February 3, 2007,
with all other variables held constant, would have resulted in a loss in the fair value of the Company’s foreign
currency forward contracts of approximately $38 million as of February 3, 2007.
Equity Price Risk
The Company, from time to time, invests its surplus cash in various securities and financial instruments,
including total return swaps, which are derivative contracts that synthetically replicate the economic return
characteristics of one or more underlying marketable equity securities. In exchange for receiving the return tied
to the position underlying a total return swap, the Company pays a floating rate of interest tied to LIBOR on the
notional amount of the contract. The fair value of a total return swap is based on the quoted market price of the
underlying position and changes in fair value of the total return swaps are recognized currently in earnings.
During fiscal 2006, the Company entered into total return swaps and recognized $74 million of investment
income, consisting of realized gains of $84 million and unrealized losses of $2 million less $8 million of interest
cost. As of February 3, 2007, the total return swaps had an aggregate notional amount of $375 million and a fair
value of $5 million.
These investments are highly concentrated and involve substantial risks. Accordingly, the Company’s
financial position and quarterly and annual results of operations may be positively or negatively materially
affected based on the timing, magnitude and performance of these investments. Based on the aggregate notional
amount of such total return swaps as of February 3, 2007, $375 million, an immediate hypothetical increase (or
decrease) of 20% in the market value underlying the total return swaps outstanding would cause the Company’s
pre-tax earnings to increase (or decrease) concurrently by $76 million. These estimates assume that the total
return swap portfolio remains constant.
Counterparties
The Company actively manages the risk of nonpayment by its derivative counterparties by limiting its
exposure to individual counterparties based on credit ratings, value at risk and maturities. The counterparties to
these instruments are major financial institutions with credit ratings of single-A or better. In certain cases,
counterparty risk is also managed through the use of collateral in the form of cash or U.S. government securities.
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