Prudential 2007 Annual Report Download - page 168

PRUDENTIAL FINANCIAL, INC.
Notes to Consolidated Financial Statements
19. DERIVATIVE INSTRUMENTS
Types of Derivative Instruments and Derivative Strategies used in a non-dealer or broker capacity
Interest rate swaps are used by the Company to manage interest rate exposures arising from mismatches between assets and liabilities
(including duration mismatches) and to hedge against changes in the value of assets it anticipates acquiring and other anticipated
transactions and commitments. Swaps may be attributed to specific assets or liabilities or may be used on a portfolio basis. Under interest
rate swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed rate and floating rate
interest amounts calculated by reference to an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the
contract and no principal payments are made by either party. These transactions are entered into pursuant to master agreements that provide
for a single net payment to be made by one counterparty at each due date.
Exchange-traded futures and options are used by the Company to reduce risks from changes in interest rates, to alter mismatches
between the duration of assets in a portfolio and the duration of liabilities supported by those assets, and to hedge against changes in the
value of securities it owns or anticipates acquiring or selling. In exchange-traded futures transactions, the Company agrees to purchase or
sell a specified number of contracts, the values of which are determined by the values of underlying referenced investments, 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 futures and options with regulated futures commission’s merchants who are members of a trading exchange.
Currency derivatives, including exchange-traded currency futures and options, currency forwards and currency swaps, are used by the
Company to reduce 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. The Company also uses currency forwards to hedge the currency risk associated with
net investments in foreign operations and anticipated earnings of its foreign operations.
Under currency forwards, the Company agrees with other parties to deliver 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. As 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 international insurance and investment
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. These
earnings hedges do not qualify for hedge accounting.
Under currency swaps, the Company agrees with other parties to exchange, at specified intervals, the difference between one currency
and another at an 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.
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 the Company’s investment portfolio.
Forward contracts are used by the Company to manage 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 valuation models 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.
166 Prudential Financial 2007 Annual Report