eTrade 2002 Annual Report Download - page 86

Table of Contents
Index to Financial Statements
Scenario Analysis
Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the Net Present Value of Equity (“NPVE”) approach,
the present value of all existing assets, liabilities, derivatives and forward commitments are estimated and then combined to produce a NPVE
figure. The sensitivity of this value to changes in interest rates is then determined by applying alternative interest rate scenarios, which include,
but are not limited to, instantaneous parallel shifts up 100, 200 and 300 basis points and down 100 basis points. The down 200 and 300 basis
point scenarios are not presented because they result in negative interest rates. The sensitivity of NPVE as of December 31, 2001 and 2002 and
the limits established by the Bank’ s board of directors are listed below:
Parallel Change
in Interest Rates (bps)
Change in NPVE
As of December 31, 2002 Change in NPVE As of December 31, 2001
Board Limit
+300 -29% -13% -55%
+200 -18% -11% -30%
+100 -7% -6% -15%
Base Case — — —
-100 -2% 3% -15%
As of December 31, 2002 the Bank’ s overall interest rate risk exposure would be classified as “minimal” under the criteria published by the
OTS.
Derivative Financial Instruments
The Bank employs derivative financial instruments to help manage the Bank’ s interest rate risk. Interest rate swaps are used to lower the
duration of specific fixed-rate assets or increase the duration of specific adjustable-rate liabilities. Interest rate swaps involve the exchange of
fixed-rate and variable-rate interest payments between two parties based on a contractual underlying notional amount but do not involve the
exchange of the underlying notional amounts. Option products are utilized primarily to decrease the change of market values resulting from the
prepayment dynamics of the Bank’ s mortgage portfolios. The types of options the Bank employs are primarily Cap Options (“Caps”) and
Floors Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps benefit from increases in market interest rates while Floors
benefit from decreases in market interest rates. Payor Swaptions benefit from increases in market interest rates while Receiver Swaptions
benefit from decreases in market interest rates.
The total notional amount of derivative financial instruments relative to total assets is largely the result of the Bank’ s exposure to mortgage
securities and loans which involve both sensitivity to interest rates and sensitivity to the rates at which the borrowers exercise their option to
prepay their loans if interest rates decline. Consequently, a mortgage instrument is hedged with a combination of interest rate swaps, cap and
floor options.
At December 31, 2002, the Bank had derivatives with $9.1 billion in total notional outstanding in comparison to $11.5 billion at December 31,
2001. Interest rate swaps at December 31, 2002, were $6.2 billion in notional with an unrealized loss of $150 million. The unrealized loss was
primarily caused by the net decrease of interest rates in 2002. The Bank primarily uses “payer” positions in which the Bank pays a fixed rate of
interest on the notional amount and receives a floating rate in exchange. The terms and conditions of the swaps are intended to be
industry-standard to maintain the liquidity of the instruments. At December 31, 2002, the notional amounts of options were $350 million in
caps, $375 million in floors and $2.1 billion in swaptions. At December31, 2001, the notional amounts of options were $3.8 billion in caps and
$0.7 billion in floors. At September 30, 2000, the Bank had $5.3 billion in interest rate swap notional with an unrealized loss of $38.5million.
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