Fifth Third Bank 2010 Annual Report Download - page 95

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fifth Third Bancorp 93
14. DERIVATIVES
The Bancorp maintains an overall risk management strategy that
incorporates the use of derivative instruments to reduce certain
risks related to interest rate, prepayment and foreign currency
volatility. Additionally, the Bancorp holds derivative instruments
for the benefit of its commercial customers. The Bancorp does not
enter into unhedged speculative derivative positions.
The Bancorp’s interest rate risk management strategy involves
modifying the repricing characteristics of certain financial
instruments so that changes in interest rates do not adversely affect
the Bancorp’s net interest margin and cash flows. Derivative
instruments that the Bancorp may use as part of its interest rate
risk management strategy include interest rate swaps, interest rate
floors, interest rate caps, forward contracts, options and swaptions.
Interest rate swap contracts are exchanges of interest payments,
such as fixed-rate payments for floating-rate payments, based on a
common notional amount and maturity date. Interest rate floors
protect against declining rates, while interest rate caps protect
against rising interest rates. Forward contracts are contracts in
which the buyer agrees to purchase, and the seller agrees to make
delivery of, a specific financial instrument at a predetermined price
or yield. Options provide the purchaser with the right, but not the
obligation, to purchase or sell a contracted item during a specified
period at an agreed upon price. Swaptions are financial instruments
granting the owner the right, but not the obligation, to enter into
or cancel a swap.
Prepayment volatility arises mostly from changes in fair value
of the largely fixed-rate MSR portfolio, mortgage loans and
mortgage-backed securities. The Bancorp may enter into various
free-standing derivatives (principal-only swaps, swaptions, floors,
options and interest rate swaps) to economically hedge prepayment
volatility. Principal-only swaps are total return swaps based on
changes in the value of the underlying mortgage principal-only
trust.
Foreign currency volatility occurs as the Bancorp enters into
certain loans denominated in foreign currencies. Derivative
instruments that the Bancorp may use to economically hedge these
foreign denominated loans include foreign exchange swaps and
forward contracts.
The Bancorp also enters into derivative contracts (including
foreign exchange contracts, commodity contracts and interest rate
swaps, floors and caps) for the benefit of commercial customers
and other business purposes. The Bancorp may economically
hedge significant exposures related to these free-standing
derivatives by entering into offsetting third-party contracts with
approved, reputable counterparties with substantially matching
terms and currencies. Credit risk arises from the possible inability
of counterparties to meet the terms of their contracts. The
Bancorp’s exposure is limited to the replacement value of the
contracts rather than the notional, principal or contract amounts.
Credit risk is minimized through credit approvals, limits,
counterparty collateral and monitoring procedures.
The Bancorp’s derivative assets consist primarily of contracts
in which the Bancorp requires the counterparties to provide
collateral in the form of cash and securities to offset changes in the
fair value of the derivatives, including changes in the fair value due
to credit risk of the counterparty. As of December 31, 2010 and
2009, the balance of collateral held by the Bancorp for derivative
assets was $903 million and $548 million, respectively. Valuation
adjustments related to the credit risk associated with certain
counterparties of customer accommodation derivative contracts
negatively impacted the fair value of those contracts by $2 million
and $3 million at December 31, 2010 and 2009, respectively.
In measuring the fair value of derivative liabilities, the
Bancorp considers its own credit risk, taking into consideration
collateral maintenance requirements of certain derivative
counterparties and the duration of instruments with counterparties
that do not require collateral maintenance. The Bancorp’s
derivative liabilities consist primarily of contracts that require
collateral to be maintained in the form of cash and securities to
offset changes in fair value of the derivatives, including changes in
fair value due to the Bancorp’s credit risk. As of December 31,
2010 and 2009, the balance of collateral posted by the Bancorp for
derivative liabilities was $680 million and $726 million, respectively.
The posting of collateral has been determined to remove the need
for consideration of credit risk. As a result, the Bancorp
determined that the impact of the Bancorp’s credit risk to the
valuation of its derivative liabilities was immaterial to the
Bancorp’s Consolidated Financial Statements.
The Bancorp holds certain derivative instruments that qualify
for hedge accounting treatment and are designated as either fair
value hedges or cash flow hedges. Derivative instruments that do
not qualify for hedge accounting treatment, or for which hedge
accounting is not established, are held as free-standing derivatives
and provide the Bancorp an economic hedge. All customer
accommodation derivatives are held as free-standing derivatives.
The fair value of derivative instruments is presented on a
gross basis, even when the derivative instruments are subject to
master netting arrangements. Derivative instruments with a
positive fair value are reported in other assets in the Consolidated
Balance Sheets while derivative instruments with a negative fair
value are reported in other liabilities in the Consolidated Balance
Sheets. Cash collateral payables and receivables associated with the
derivative instruments are not added to or netted against the fair
value amounts.