Prudential 2001 Annual Report Download - page 98

Prudential Financial, Inc.
Derivatives
Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial
indices, or the prices of securities or commodities. Derivative financial instruments may be exchange-traded or
contracted in the over-the-counter market and include swaps, futures, options and forward contracts. See Note 19 to
the Consolidated Financial Statements for a summary of our derivative positions as of December 31, 2001 and 2000.
Under insurance statutes, our insurance companies may use derivative financial instruments to hedge actual or
anticipated changes in their assets or liabilities, to replicate cash market instruments or for certain income-
generating activities. These statutes generally prohibit the use of derivatives for speculative purposes. We use
derivative financial instruments to seek to reduce market risk from changes in interest rates or foreign currency
exchange rates, and to alter interest rate or foreign currency exposures arising from mismatches between assets and
liabilities. In addition, derivatives are used in our securities operations for trading purposes.
Trading Activities
We engage in trading activities primarily in connection with our securities businesses. We maintain trading
inventories in various equity and fixed-income securities, foreign exchange instruments and commodities, primarily
to facilitate transactions for our clients. Market risk affects the values of our trading inventories through fluctuations
in absolute or relative interest rates, credit spreads, foreign currency exchange rates, securities and commodity
prices. We seek to use short security positions and forwards, futures, options and other derivatives to limit exposure
to interest rate and other market risks. We also trade derivative financial instruments that allow our clients to
manage exposure to interest rate, currency and other market risks. Most of our derivative transactions involve
exchange-listed contracts and are short-term in duration. We act both as a broker, by selling exchange-listed
contracts, and as a dealer, by entering into futures and security transactions as a principal. As a broker, we assume
counterparty and credit risks that we seek to mitigate by using margin or other credit enhancements and by
establishing trading limits and credit lines. As a dealer, we are subject to market risk as well as counterparty and
credit risk. We manage the market risk associated with trading activities through hedging activities and formal
policies, risk and position limits, counterparty and credit limits, daily position monitoring, and other forms of risk
management.
Value-at-Risk
VaR is one of the tools we use to monitor and manage our exposure to the market risk of our trading activities. We
calculate a VaR that encompasses our trading activities using a 95% confidence level. The VaR method incorporates
the risk factors to which the market value of our trading activities is exposed, which consist of interest rates,
including credit spreads, foreign exchange rates, equity prices and commodity prices, estimates of volatilities from
historical data, the sensitivity of our trading activities to changes in those market factors and the correlations of
those factors. We regularly test our VaR model by comparing actual adverse results to those estimated by the VaR
model with a 95% confidence level over a one-day time horizon. The VaR for our trading activities expressed in
terms of adverse changes to fair value at the 95% confidence level over a one-day time horizon was $5 million at
December 31, 2001 and $6 million at December 31, 2000. The average daily VaR for our trading activities,
expressed in terms of adverse changes to fair value with a 95% confidence level over a one-day time horizon, was
$6 million during 2001 and $9 million during 2000. The following table sets forth a breakdown of this VaR by risk
component as follows:
As of
December 31,
2001
Average
for
2001
As of
December 31,
2000
Average
for
2000
(in millions)
Interest rate risk ........................................................ $ 5 $5 $4 $6
Equity risk ............................................................ —123
Total(1) .......................................................... $ 5 $6 $6 $9
(1) At December 31, 2001 and 2000, and during the years then ended, VaR from each of foreign currency exchange rate risk and commodity
risk in our trading activities was immaterial.
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