eTrade 2008 Annual Report Download - page 86

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
portfolio, 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. See derivative financial instruments discussion at Note 9—
Accounting for Derivative Financial Instruments and Hedging Activities in Item 8. Financial Statements and
Supplementary Data.
Scenario Analysis
Scenario analysis is an advanced approach to estimating interest rate risk exposure. Under the 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 and 200 basis points. The NPVE method is used at
the E*TRADE Bank level and not for the Company.
E*TRADE Bank has 98% and 96% of our enterprise interest-earning assets at December 31, 2008 and 2007,
respectively, and holds 98% and 96% of our enterprise interest-bearing liabilities at December 31, 2008 and
2007, respectively. The sensitivity of NPVE at December 31, 2008 and 2007 and the limits established by
E*TRADE Bank’s Board of Directors are listed below (dollars in thousands):
Change in NPVE
Board
Limit
December 31,
2008 2007
Parallel Change in Interest Rates (bps) Amount Percentage Amount Percentage
+300 $ (65,600) (3)% $(434,303) (17)% (55)%
+200 $ 68,853 3 % $(323,193) (12)% (30)%
+100 $ 119,407 5 % $(174,280) (7)% (20)%
-100 $(334,132) (14)% $ 99,245 4 % (20)%
-200(1) $ — — % $ (63,785) (2)% (30)%
(1) On December 31, 2008, the yield on the three-month Treasury bill was 0.11%. As a result, the OTS temporarily modified the
requirements of the NPV Model, resulting in removal of the minus 200 basis points scenario for the year ended December 31, 2008.
Under criteria published by the OTS, E*TRADE Bank’s overall interest rate risk exposure at December 31,
2008 was characterized as “minimum.” We actively manage our interest rate risk positions. As interest rates
change, we will re-adjust our strategy and mix of assets, liabilities and derivatives to optimize our position. For
example, a 100 basis points increase in rates may not result in a change in value as indicated above. The ALCO
monitors E*TRADE Bank’s interest rate risk position.
83