eTrade 2005 Annual Report Download - page 96

Table of Contents
ITEM7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For quantitative and qualitative disclosures about market risk, we currently evaluate such risks for our brokerage and banking
operations separately. The following discussion about our market risk disclosure includes forward-looking statements. Actual results
could differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to,
those set forth in the section entitled “Risk Factors.” Market risk is our exposure to changes in interest rates, foreign exchange rates
and equity and commodity prices. Our exposure to interest rate risk is primarily related to interest-earning assets and sources of funds.
Interest Rate Risk
The management of interest rate risk is essential to profitability. Interest rate risk is our exposure to changes in interest rates. In
general, we manage our interest rate risk by balancing variable and fixed assets, liabilities and derivatives in a way that reduces the
overall exposure to changes in interest rates. This analysis is based on complex assumptions regarding maturities, market interest rates
and customer behavior. Changes in interest rates including the following could impact interest income and expense:
•
Interest-bearing assets and liabilities may re-price at different times or by different amounts creating a mismatch.
•
The yield curve may flatten or change shape affecting the spread between short and long term rates. Widening or narrowing
spreads could impact net interest income.
•
Market interest rates may influence prepayments resulting in maturity mismatches. In addition, prepayments could impact yields
as premium and discounts amortize.
Exposure to market risk is dependent upon the distribution of interest-bearing assets, liabilities and derivatives. The differing risk
characteristics of each product are managed to mitigate our exposure to interest rate fluctuations. At December31, 2005, 92% of our
total assets were interest-earning. Approximately 80% of interest-earning assets are variable meaning that they re-price periodically
based on market interest rates.
At December31, 2005, approximately 58% of our total assets were residential mortgages and mortgage-backed securities. The values of
these assets are sensitive to changes in interest rates, as well as expected prepayment levels. As interest rates increase, residential
mortgages and mortgage-backed securities tend to exhibit lower prepayments. The inverse is true in a falling rate environment.
Our liability structure consists of brokerage payables, transactional deposit relationships, such as money market accounts, certificates
of deposit, wholesale collateralized borrowings from the FHLB and other entities, securities sold under agreements to repurchase and
long term notes. Our transactional deposit accounts tend to be less rate-sensitive then other deposit account types. Brokerage
payables, agreements to repurchase securities and money market accounts re-price as interest rates change. Certificates of deposit
re-price over time depending on maturities. FHLB advances and long term notes generally have fixed rates.
Derivative Financial Instruments
We use derivative financial instruments to help manage our interest rate risk. 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 market value changes resulting
from the prepayment dynamics of the mortgage portfolios, as well as to protect against increases in funding costs. The types of
options employed include Cap Options (“Caps”) and Floor Options (“Floors”), “Payor Swaptions” and “Receiver Swaptions.” Caps
mitigate the market risk associated with increases in interest rates, while Floors mitigate the risk associated with decreases in market
interest rates. Similarly, Payor and Receiver Swaptions mitigate the market risk associated with the respective increases and decreases
in interest rates.
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