Prudential 2007 Annual Report Download - page 97

Market Risk Related to Foreign Currency Exchange Rates
We are exposed to foreign currency exchange rate risk in our domestic general account investment portfolios, other proprietary
investment portfolios and through our operations in foreign countries.
Our exposure to foreign currency risk within the domestic general account investment portfolios supporting our U.S. insurance
operations and other domestic proprietary investment portfolios arises primarily from investments that are denominated in foreign
currencies. We generally hedge substantially all domestic general account foreign currency-denominated fixed-income investments and
other domestic proprietary foreign currency investments into U.S. dollars in order to mitigate the risk that the cash flows or fair value of
these investments fluctuates as a result of changes in foreign currency exchange rates. We generally do not hedge all of the foreign
currency risk of our investments in equity securities of unaffiliated foreign entities.
Our operations in foreign countries create the following three additional sources of foreign currency risk:
• First, we reflect the operating results of our foreign operations in our financial statements based on the average exchange rates
prevailing during the period. We hedge some of these foreign currency operating results as part of our overall risk management
strategy. We generally hedge our anticipated exposure to adjusted operating income fluctuations resulting from changes in foreign
currency exchange rates relating to our International operations primarily in Japan, Korea, Taiwan and Europe.
• 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. To mitigate potential losses due to fluctuations in these exchange rates, for our equity
investments in our International operations other than in Japan and Taiwan, we generally hedge a significant portion of this
exposure 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,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of
Operations for Financial Services Businesses by Segment—International Insurance and Investments Division.”
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, 2007 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 $46 million, representing a hypothetical decline in fair market value of these foreign currency assets from $1.798 billion to $1.752
billion. 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 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 $35 million during
2007 and $39 million during 2006. 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 $73 million as of December 31, 2007 and $71 million as of December 31, 2006.
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. We are also a party to financial instruments that may contain derivative
instruments that are embedded in the financial instruments. See Note 19 to the Consolidated Financial Statements for a description of our
derivative activities as of December 31, 2007 and 2006. 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.
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