Prudential 2001 Annual Report Download - page 146

Prudential Financial, Inc.
Notes to Consolidated Financial Statements
19. Derivative Instruments (continued)
either modify or hedge existing interest rate risk. This strategy protects against the risk that cash flow requirements
may necessitate liquidation of investments at unfavorable prices resulting from increases in interest rates. This
strategy can be a more cost effective way of temporarily reducing the Company’s exposure to a market decline than
selling fixed income securities and purchasing a similar portfolio when such a decline is believed to be over.
When the Company anticipates a significant decline in the stock market that will correspondingly affect its
diversified portfolio, it may purchase put index options where the basket of securities in the index is appropriate to
provide a hedge against a decrease in the value of the Company’s equity portfolio or a portion thereof. This strategy
effects an orderly sale of hedged securities. When the Company has large cash flows which it has allocated for
investment in equity securities, it may purchase call index options as a temporary hedge against an increase in the
price of the securities it intends to purchase. This hedge is intended to permit such investment transactions to be
executed with less adverse market impact.
Currency derivatives, including exchange-traded currency futures and options, currency forwards and currency
swaps, are used by the Company to reduce market risks from changes in currency exchange rates with respect to
investments denominated in foreign currencies that the Company either holds or intends to acquire or sell.
Under exchange-traded currency futures and options, the Company agrees to purchase or sell a specified number of
contracts and to post variation margin on a daily basis in an amount equal to the difference in the daily market
values of those contracts. The Company enters into exchange-traded currency futures and options with regulated
futures commissions merchants who are members of a trading exchange.
Under currency forwards, the Company agrees with other parties upon delivery of a specified amount of an
identified currency at a specified future date. Typically, the price is agreed upon at the time of the contract and
payment for such a contract is made at the specified future date. In addition to managing the risks noted above, the
Company uses currency forwards to mitigate the risk that unfavorable changes in currency exchange rates will
reduce U.S. dollar equivalent earnings generated by certain of its non-U.S. businesses, primarily its Japanese
insurance operations. The Company executes forward sales of the hedged currency in exchange for U.S. dollars at a
specified exchange rate. The maturities of these forwards correspond with the future periods in which the non-U.S.
earnings are expected to be generated. When contracts are terminated, in the same period as the expected earnings,
the resulting positive or negative cash flow is included in “Commissions and other income” (revenues of $34
million in 2001 and $22 million in 2000). Changes in the fair value of open contracts are included in “Realized
investment gains (losses), net.” At December 31, 2001, the fair value of open contracts used for this purpose was
$78 million.
Under currency swaps, the Company agrees with other parties to exchange, at specified intervals, the difference
between one currency and another at a forward exchange rate and calculated by reference to an agreed principal
amount. Generally, the principal amount of each currency is exchanged at the beginning and termination of the
currency swap by each party. These transactions are entered into pursuant to master agreements that provide for a
single net payment to be made by one counterparty for payments made in the same currency at each due date.
Forward contracts are used by the Company to manage market risks relating to interest rates and commodities and
trades in mortgage-backed securities forward contracts. The latter activity was exited in connection with the
restructuring of Prudential Securities Group Inc.’s capital markets activities as discussed in Note 4. Typically, the
price is agreed upon at the time of the contract and payment for such a contract is made at the specified future date.
The tables below summarize the Company’s outstanding positions by derivative instrument types at December 31,
2001 and 2000. The amounts presented are classified as either trading or other than trading, based on management’s
intent at the time of contract inception and throughout the life of the contract. The table includes the estimated fair
values of outstanding derivative positions only and does not include the changes in fair values of associated
financial and non-financial assets and liabilities, which generally offset derivative gains and losses. The fair value
amounts presented also do not reflect the netting of amounts pursuant to right of setoff, qualifying master netting
agreements with counterparties or collateral arrangements.
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