Prudential 2006 Annual Report Download - page 89

• Second, we translate our equity investment in foreign operations into U.S. dollars using the foreign currency exchange rate at the
financial statement period-end date. For our equity investments in our International operations, other than in Japan and Taiwan, we
generally hedge a significant portion of this exposure, which we accomplish through the use of foreign currency forward contracts.
For our equity investments in our Japanese and Taiwanese operations we generally hedge this exposure by holding U.S. dollar
denominated securities in the investment portfolios of these operations.
• Third, our international insurance operations may hold investments denominated in currencies other than the functional currency of
those operations on an unhedged basis in addition to the aforementioned equity hedges resulting from foreign subsidiaries’
investing in U.S. dollar denominated investments. Most significantly, our Japanese operations hold U.S. dollar denominated
investments in their investment portfolios in excess of our equity investment in such operations. For a discussion of our Japanese
operations’ U.S. dollar denominated investment holdings, see “Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Realized Investment Gains and General Account Investments—General Account Investments—Portfolio
Composition.”
We manage our investment foreign currency exchange rate risks, described above, within specified limits. Foreign currency exchange
risks for our domestic general account investment portfolio and the unhedged portion of our equity investment in foreign subsidiaries are
managed using VaR-based analysis. This statistical technique estimates, at a specified confidence level, the potential pre-tax loss in
portfolio market value that could occur over an assumed time horizon due to adverse market movements.
The estimated VaR as of December 31, 2006 for foreign currency exchange risks in our domestic general account portfolio and the
unhedged portion of equity investment in foreign subsidiaries, measured at a 95% confidence level and using a one-month time horizon,
was $34 million, representing a hypothetical decline in fair market value of these foreign currency assets from $1.468 billion to $1.434
billion. The estimated VaR as of December 31, 2005 for foreign currency exchange risks in our domestic general account portfolio and the
unhedged portion of equity investment in foreign subsidiaries, measured at a 95% confidence level and using a one-month time horizon,
was $20 million, representing a hypothetical decline in fair market value of these foreign currency assets from $967 million to $947
million. The average VaR for foreign currency exchange risks in our domestic general account portfolio and the unhedged portion of equity
investment in foreign subsidiaries, measured monthly at a 95% confidence level over a one month time horizon, was $39 million during
2006 and $32 million during 2005. These calculations use historical price volatilities and correlation data at a 95% confidence level. We
discuss limitations of VaR models below.
The estimated VaR for instruments 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 a 95% confidence level and using a
one-month time horizon, was $71 million as of December 31, 2006 and $75 million as of December 31, 2005.
Derivatives
Derivatives are financial instruments whose values are derived from interest rates, foreign currency 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 description of
our derivative activities as of December 31, 2006 and 2005. 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, foreign currency exchange rates, as well as equity prices,
and to alter interest rate or foreign currency exposures arising from mismatches between assets and liabilities. In addition, we use derivative
financial instruments to mitigate risk associated with some of our benefit features of our variable annuity contracts.
Trading Activities
We engage in trading activities primarily in connection with our equity and derivatives trading operations. We maintain trading
positions in various equity, foreign exchange instruments and commodities, primarily to facilitate transactions for our clients. Market risk
affects the values of our trading positions through fluctuations in absolute or relative interest rates, 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. Our derivative transactions involve both exchange-listed and over-the-counter contracts and
are generally short-term in duration. We act both as a broker, buying and selling exchange-listed contracts for our customers, 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 currency exchange rates, equity
prices and commodity prices, estimates of volatilities from historical data, the sensitivity of our trading activities to changes in those market
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