Prudential 2003 Annual Report Download - page 94

We calculate VaR estimates of exposure to loss from volatility in foreign currency exchange rates for one-month
time periods. Our estimated VaR as of December 31, 2003 for foreign currency assets not hedged to U.S. dollars,
measured at the 95% confidence level and using a one-month time horizon, was $24 million, representing a
hypothetical decline in fair market value of these foreign currency assets from $811 million to $787 million. Our
estimated VaR as of December 31, 2002 for foreign currency assets not hedged to U.S. dollars, measured at the 95%
confidence level and using a one-month time horizon, was $9 million, representing a hypothetical decline in fair
market value of these foreign currency assets from $494 million to $485 million. These calculations use historical price
volatilities and correlation data at a 95% confidence level. We discuss limitations of VaR models below. Our estimated
VaR for foreign exchange forward contracts and currency swaps used to hedge our anticipated exposure to adjusted
operating income fluctuations resulting from changes in foreign currency exchange rates relating to our international
operations, measured at the 95% confidence level and using a one-month time horizon, was $59 million as of
December 31, 2003 and $110 million as of December 31, 2002.
Our average monthly Value-at-Risk for foreign currency assets not hedged to U.S. dollars from foreign currency
exchange rate movements, measured at the 95% confidence level over a one month time horizon, was $18 million
during 2003 and $15 million during 2002.
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 18 to
the Consolidated Financial Statements for a description of our derivative activities as of December 31, 2003 and 2002.
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 primarily 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 futures operations for trading purposes.
Trading Activities
We engage in trading activities primarily in connection with our equity and futures operations, as well as,
historically, in our former domestic retail securities brokerage business. We maintain trading inventories in various
equity, 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
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