Prudential 2006 Annual Report Download - page 164

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
19. DERIVATIVE INSTRUMENTS (continued)
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.
Credit derivatives are used by the Company to enhance the return on the Company’s investment portfolio by creating credit
exposure similar to an investment in public fixed maturity cash instruments. With credit derivatives the Company can sell credit
protection on an identified name, or a basket of names in a first to default structure, and in return receive a quarterly premium. With
single name credit default derivatives, this premium or credit spread generally corresponds to the difference between the yield on
the referenced name’s public fixed maturity cash instruments and swap rates, at the time the agreement is executed. With first to
default baskets, the premium generally corresponds to a high proportion of the sum of the credit spreads of the names in the basket.
If there is an event of default by the referenced name or one of the referenced names in a basket, as defined by the agreement, then
the Company is obligated to pay the counterparty the referenced amount of the contract and receive in return the referenced
defaulted security or similar security. See Note 21 for a discussion of guarantees related to these credit derivatives. In addition to
selling credit protection, in limited instances the Company has purchased credit protection using credit derivatives in order to hedge
specific credit exposures in our investment portfolio.
Forward contracts are used by the Company to manage market risks relating to interest rates. The Company also uses “to be
announced” (“TBA”) forward contracts to gain exposure to the investment risk and return of mortgage-backed securities. TBA
transactions can help the Company to achieve better diversification and to enhance the return on its investment portfolio. TBAs
provide a more liquid and cost effective method of achieving these goals than purchasing or selling individual mortgage-backed
pools. Typically, the price is agreed upon at the time of the contract and payment for such a contract is made at a specified future
date.
In its mortgage operations, the Company enters into commitments to fund commercial mortgage loans at specified interest
rates and other applicable terms within specified periods of time. These commitments are legally binding agreements to extend
credit to a counterparty. Loan commitments for loans that will be held for sale are recognized as derivatives and recorded at fair
value. The determination of the fair value of loan commitments accounted for as derivatives considers various factors including,
among others, terms of the related loan, the intended exit strategy for the loans based upon either a securitization pricing model or
investor purchase commitments, prevailing interest rates, and origination income or expense. Loan commitments that relate to the
origination of mortgage loans that will be held for investment are not accounted for as derivatives and accordingly are not
recognized in the Company’s financial statements. See Note 21 for a further discussion of these loan commitments.
When the Company has cash flows that it has allocated for investment in equity securities or plans to sell investments in equity
securities, it may enter into equity derivatives as a temporary hedge against an increase or decrease in the price of the securities it
intends to purchase or sell. These hedges are intended to permit such investment transactions to be executed with less adverse
market impacts. The Company also uses equity-based derivatives to hedge the equity risks embedded in some of its annuity
products.
As further described in Note 9, the Company sells variable annuity products which contain embedded derivatives. These
embedded derivatives are marked to market through “Realized investment gains (losses), net” based on the change in value of the
underlying contractual guarantees which are determined using pricing models.
The Company invests in fixed maturities that, in addition to a stated coupon, provide a return based upon the results of an
underlying portfolio of fixed income investments and related investment activity. The Company accounts for these investments as
available for sale fixed maturities containing embedded derivatives. Such embedded derivatives are marked to market through
“Realized investment gains (losses), net,” based upon the change in value of the underlying portfolio.
PRUDENTIAL FINANCIAL, INC. 2006 ANNUAL REPORT
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