Charles Schwab 2008 Annual Report Download - page 54

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THE CHARLES SCHWAB CORPORATION
- 40 -
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the potential for changes in revenue or the value of financial instruments held by the Company as a result of
fluctuations in interest rates, equity prices or market conditions.
For the Company’s market risk related to interest rates, a sensitivity analysis, referred to as a net interest revenue simulation
model, is shown below. The Company is exposed to interest rate risk primarily from changes in the interest rates on its
interest-earning assets relative to changes in the costs of its funding sources which finance these assets.
Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and
interest bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing
liabilities, which may re-price at different times or by different amounts, and the spread between short and long term interest
rates. Interest earning-assets include residential real estate loans and mortgage backed securities. These assets are sensitive to
changes in interest rates and to changes to prepayment levels, which tend to increase in a declining rate environment.
To mitigate the risk of loss, the Company has established policies and procedures which include setting guidelines on the
amount of net interest revenue at risk, and monitoring the net interest margin and average maturity of its interest-earning
assets and funding sources. To remain within these guidelines, the Company manages the maturity, repricing, and cash flow
characteristics of its investment portfolios. Because the Company establishes the rates paid on certain brokerage client cash
balances and deposits from banking clients, the rates charged on margin loans, and controls the composition of its investment
securities, it has some ability to manage its net interest spread, depending on competitive factors and market conditions.
The Company is also subject to market risk as a result of fluctuations in equity prices. The Company’s direct holdings of
equity securities and its associated exposure to equity prices are not material. The Company is indirectly exposed to equity
market fluctuations in connection with securities collateralizing margin loans to brokerage customers, and customer securities
loaned out as part of the Company’s securities lending activities. Equity market valuations may also affect the level of
brokerage client trading activity, margin borrowing, and overall client engagement with the Company. Additionally, the
Company earns mutual fund service fees and asset management fees based upon daily balances of certain client assets.
Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue
earned by the Company.
Financial instruments held by the Company are also subject to liquidity risk – that is, the risk that valuations will be
negatively affected by changes in demand and the underlying market for a financial instrument. Recent conditions in the
credit markets have significantly reduced market liquidity in a wide range of financial instruments, including the types of
instruments held by the Company, and fair value can differ significantly from the value implied by the credit quality and
actual performance of the instrument’s underlying cash flows.
Financial instruments held by the Company are also subject to valuation risk as a result of changes in valuations of the
underlying collateral, such as housing prices in the case of residential real estate loans and mortgage-backed securities.
For discussion of the impact of current market conditions on asset management and administration fees, net interest revenue,
and securities available for sale, see “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of
Operations – Current Market Environment”.
The Company’s market risk related to financial instruments held for trading, interest rate swaps related to a portion of its
fixed interest rate medium-term notes, and forward sale and interest rate lock commitments related to its loans held for sale
portfolio is not material.
Net Interest Revenue Simulation
The Company uses net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest
rates. The simulation model (the model) includes all interest-sensitive assets and liabilities, as well as interest rate swap
agreements utilized by the Company to hedge its interest rate risk. Key variables in the model include the repricing of
financial instruments, prepayment and reinvestment assumptions, and product pricing assumptions. The Company uses