US Bank 2001 Annual Report Download - page 40

Use of Derivatives to Manage Market and Interest Rate enters into legally enforceable master netting agreements,
Risk In the ordinary course of business, the Company which permit the close out and netting of transactions with
enters into derivative transactions to manage its market and the same counterparty upon the occurrence of certain
prepayment risks and to accommodate the business events. Also, a portion of the derivative activity involves
requirements of its customers. By their nature, derivative exchange-traded instruments. Because exchange-traded
instruments are subject to market risk. The Company does instruments conform to standard terms and are subject to
not utilize derivative instruments for speculative purposes. policies set by the exchange involved, including
To manage its interest rate risk, the Company may enter counterparty approval, margin requirements and security
into interest rate swap agreements and, to a lesser degree, deposit requirements, the credit risk is substantively
basis swaps, and interest rate options such as caps and reduced.
Öoors. Interest rate swaps involve the exchange of Ñxed- Table 17 summarizes information on derivative
and variable-rate payments without the exchange of the positions as of December 31, 2001.
underlying notional amount on which the interest payments Market Risk Management In addition to interest rate risk
are calculated. Interest rate caps protect against rising and market risk associated with derivatives, the Company is
interest rates while interest rate Öoors protect against falling exposed to other forms of market risk as a consequence of
interest rates. In connection with its mortgage banking conducting normal business activities. Business activities that
business, the Company may enter into forward contribute to market risk include, among other things,
commitments, futures and options to hedge interest rate market making, underwriting, proprietary trading and
risk of Ñxed-rate mortgage loans held for sale and unfunded foreign exchange positions. Value at Risk (""VaR'') is a key
commitments. All interest rate derivatives that qualify for measure of market risk for the Company. VaR represents
hedge accounting are recorded at fair value as other assets the maximum amount that the Company has placed at risk
or liabilities on the balance sheet and designated as either of loss, with a ninety-nine percent degree of conÑdence, in
""fair value'' or ""cash Öow'' hedges. The Company performs the course of its risk taking activities. Its purpose is to
an assessment, both at the inception of the hedge and describe the amount of earnings at risk due to potential
quarterly thereafter, to determine whether these derivatives losses from adverse market movements.
are highly eÅective in oÅsetting changes in the value of the VaR modeling on trading activities is subject to certain
hedged items. Hedge ineÅectiveness for both cash Öow and limitations. Additionally, it should be recognized that there
fair value hedges is immediately recorded in noninterest are assumptions and estimates associated with VaR
income. modeling and actual results could diÅer from these
The Company also enters into derivative contracts to assumptions and estimates. The Company mitigates these
accommodate the business requirements of its customers. uncertainties through regular monitoring of trading activities
Customer intermediated transactions may include interest by management and other risk management practices
rate derivatives and foreign exchange forward contracts and including stop-loss limits and position limits. A stress-test
options. Foreign exchange-based forward contracts provide model is used to provide management with a perspective on
for the delayed delivery of a purchase or sale of foreign market events that a VaR model does not capture. In each
currency. Generally, the Company enters into oÅsetting case, the historical worst performance of each asset class is
derivative positions to mitigate its market risk associated observed and applied to current trading positions.
with customer-based contracts. Intermediated interest rate ALPC establishes market risk limits subject to approval
swaps, foreign exchange contracts and all other derivative by the Company's Board of Directors. The Company's VaR
contracts that do not qualify for hedge accounting are limit was $40.0 million at December 31, 2001. The market
recorded at fair value and resulting gains or losses are risk inherent in the Company's customer-based derivative
recorded in trading account proÑts and commissions. trading, mortgage banking pipeline, broker-dealer activities,
Derivative instruments are subject to credit risk associated including equities, Ñxed income, high yield securities and
with counterparties to the derivative contracts. Credit risk foreign exchange, as estimated by the VaR analysis, was
associated with derivatives is measured based on the $10.9 million at December 31, 2001.
replacement cost should the counterparties with contracts
in a gain position to the Company fail to perform under the Liquidity Risk Management ALPC establishes policies, as
terms of the contracts. The Company manages this risk well as analyzes and manages liquidity, to ensure that
through diversiÑcation of its derivative positions among adequate funds are available to meet normal operating
dealers, primarily commercial banks, broker-dealers and requirements in addition to unexpected customer demands
corporations, with established relationships and requiring for funds, such as high levels of deposit withdrawals or
collateral to support credit exposures in excess of loan demand, in a timely and cost-eÅective manner. The
established guidelines. To minimize the risk, the Company most important factor in the preservation of liquidity is
U.S. Bancorp
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