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The Corporation designates a derivative as held for trading or hedging purposes when it enters into the derivative contract. The designation may change based upon management's intentions and changing circumstances. Derivatives utilized by the Corporation include swaps, financial futures and forward settlement contracts, and option contracts. A swap agreement is a contract between two parties to exchange cash flows based on specified underlying notional amounts, assets and/or indices. Financial futures and forward settlement contracts are agreements to buy or sell a quantity of a financial instrument, index, currency or commodity at a predetermined future date and rate or price. An option contract is an agreement that conveys to the purchaser the right, but not the obligation, to buy or sell a quantity of a financial instrument, index, currency or commodity at a predetermined rate or price during a period or at a time in the future. Option agreements can be transacted on organized exchanges or directly between parties. The Corporation also provides credit derivatives to customers who wish to hedge existing credit exposures or take on credit exposure to generate revenue.
Credit Risk Associated with Derivative ActivitiesCredit risk associated with derivatives is measured as the net replacement cost should the counterparties with contracts in a gain position to the Corporation completely fail to perform under the terms of those contracts assuming no recoveries of underlying collateral. In managing derivative credit risk, both the current exposure, which is the replacement cost of contracts on the measurement date, as well as an estimate of the potential change in value of contracts over their remaining lives are considered. The Corporation's derivative activities are primarily with commercial banks, broker/dealers and corporations. To minimize credit risk, the Corporation enters into legally enforceable master netting agreements, which reduce risk by permitting the closeout and netting of transactions with the same counterparty upon occurrence of certain events. In addition, the Corporation reduces credit risk by obtaining collateral based on individual assessment of counterparties. The determination of the need for and the levels of collateral will vary depending on the Corporation's credit risk rating of the counterparty. Generally, the Corporation accepts collateral in the form of cash, U.S. Treasury securities and other marketable securities. The Corporation held $24.0 billion of collateral on derivative positions, of which $15.7 billion could be applied against credit risk at December 31, 2003.
A portion of the derivative activity involves exchange-traded instruments. Exchange-traded instruments conform to standard terms and are subject to policies set by the exchange involved, including counterparty approval, margin requirements and security deposit requirements. Management believes the credit risk associated with these types of instruments is minimal.
The following table presents the contract/notional and credit risk amounts at December 31, 2003 and 2002 of the Corporation's derivative positions held for trading and hedging purposes. These derivative positions are primarily executed in the over-the-counter market. The credit risk amounts presented in the following table do not consider the value of any collateral held but take into consideration the effects of legally enforceable master netting agreements.
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| Derivatives(1) |
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December 31, 2003 |
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December 31, 2002 |
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Contact/
Notional |
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Credit
Risk |
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Contact/
Notional |
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Credit
Risk |
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| Interest rate contracts |
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| Swaps |
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$ |
8,873,600 |
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$ |
14,893 |
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$ |
6,781,629 |
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$ |
18,981 |
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| Futures and forwards |
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2,437,907 |
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|
633 |
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2,510,259 |
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283 |
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| Written options |
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1,174,014 |
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- |
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973,113 |
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- |
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| Purchased options |
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1,132,486 |
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3,471 |
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907,999 |
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3,318 |
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| Foreign exchange contracts |
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| Swaps |
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260,210 |
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4,473 |
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175,680 |
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2,460 |
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| Spot, futures and forwards |
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775,105 |
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4,202 |
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724,039 |
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2,535 |
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| Written options |
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138,474 |
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- |
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81,263 |
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- |
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| Purchased options |
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133,512 |
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669 |
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80,395 |
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452 |
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| Equity contracts |
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| Swaps |
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30,850 |
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364 |
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16,830 |
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|
679 |
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| Futures and forwards |
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3,234 |
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- |
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48,470 |
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- |
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| Written options |
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25,794 |
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- |
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19,794 |
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- |
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| Purchased options |
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24,119 |
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5,370 |
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23,756 |
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2,885 |
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| Commodity contracts |
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| Swaps |
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15,491 |
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1,554 |
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11,776 |
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1,117 |
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| Futures and forwards |
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5,726 |
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- |
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3,478 |
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- |
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| Written options |
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11,695 |
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- |
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12,158 |
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- |
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| Purchased options |
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7,223 |
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294 |
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19,115 |
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347 |
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| Credit derivatives |
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136,788 |
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584 |
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92,098 |
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1,253 |
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| Total derivative assets |
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$ |
36,507 |
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$ |
34,310 |
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The average fair value of derivative assets for 2003 and 2002 was $34.9 billion and $25.3 billion, respectively. The average fair value of derivative liabilities for 2003 and 2002 was $23.9 billion and $17.3 billion, respectively.
ALM ProcessInterest rate contracts and foreign exchange contracts are utilized in the Corporation's ALM process. The Corporation maintains an overall interest rate risk management strategy that incorporates the use of interest rate contracts to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. The Corporation's goal is to manage interest rate sensitivity so that movements in interest rates do not significantly adversely affect net interest income. As a result of interest rate fluctuations, hedged fixed-rate assets and liabilities appreciate or depreciate in market value. Gains or losses on the derivative instruments that are linked to the hedged fixed-rate assets and liabilities are expected to substantially offset this unrealized appreciation or depreciation. Interest income and interest expense on hedged variable-rate assets and liabilities, respectively, increases or decreases as a result of interest rate fluctuations. Gains and losses on the derivative instruments that are linked to these hedged assets and liabilities are expected to substantially offset this variability in earnings.
Interest rate contracts, which are generally non-leveraged generic interest rate and basis swaps, options and futures, allow the Corporation to manage its interest rate risk position. Non-leveraged generic interest rate swaps involve the exchange of fixed-rate and variable-rate interest payments based on the contractual underlying notional amount. Basis swaps involve the exchange of interest payments based on the contractual underlying notional amounts, where both the pay rate and the receive rate are floating rates based on different indices. Option products primarily consist of caps, floors, swaptions and options on index futures contracts. Futures contracts used for the ALM process are primarily index futures providing for cash payments based upon the movements of an underlying rate index.
The Corporation uses foreign currency contracts to manage the foreign exchange risk associated with certain foreign currency-denominated assets and liabilities, as well as the Corporation's equity investments in foreign subsidiaries. Foreign exchange contracts, which include spot, futures and forward contracts, represent agreements to exchange the currency of one country for the currency of another country at an agreed-upon price on an agreed-upon settlement date. Foreign exchange option contracts are similar to interest rate option contracts except that they are based on currencies rather than interest rates. Exposure to loss on these contracts will increase or decrease over their respective lives as currency exchange and interest rates fluctuate.
Fair Value and Cash Flow HedgesThe Corporation uses various types of interest rate and foreign currency exchange rate derivative contracts to protect against changes in the fair value of its fixed-rate assets and liabilities due to fluctuations in interest rates and exchange rates. The Corporation also uses these contracts to protect against changes in the cash flows of its variable-rate assets and liabilities, and anticipated transactions. In 2003, the Corporation recognized in the Consolidated Statement of Income a net loss of $101 million (included in interest income) related to fair value hedges. This loss represents the expected change in the forward values of forward contracts and was excluded from the assessment of hedge effectiveness. In 2002, the Corporation recognized in the Consolidated Statement of Income a net loss of $22 million (included in interest income) that was excluded from the assessment of hedge effectiveness related to fair value hedges. In 2003, the Corporation recognized in the Consolidated Statement of Income net gains of $26 million (included in mortgage banking income) that represented the amount excluded from the assessment of hedge effectiveness related to cash flow hedges. In 2002, the Corporation recognized in the Consolidated Statement of Income a net loss of $28 million (included in interest income and mortgage banking income) that represented the amount excluded from the assessment of hedge effectiveness related to cash flow hedges. At December 31, 2003 and 2002, the Corporation has determined that there were no hedging positions where it was probable that certain forecasted transactions may not occur within the originally designated time period. The Corporation did not recognize material amounts in the Consolidated Statement of Income related to ineffectiveness of fair value or cash flow hedges in 2003 or 2002.
For cash flow hedges, gains and losses on derivative contracts reclassified from accumulated OCI to current period earnings are included in the line item in the Consolidated Statement of Income in which the hedged item is recorded and in the same period the hedged item affects earnings. During the next 12 months, net gains on derivative instruments included in accumulated OCI, of approximately $825 million (pre-tax) are expected to be reclassified into earnings. These net gains reclassified into earnings are expected to increase income or decrease expense on the respective hedged items.
Hedges of Net Investments in Foreign OperationsThe Corporation uses forward exchange contracts, currency swaps and nonderivative cash instruments that provide an economic hedge on portions of its net investments in foreign operations against adverse movements in foreign currency exchange rates. In 2003 and 2002, the Corporation experienced net unrealized foreign currency pre-tax gains of $197 million and $103 million, respectively, related to its net investments in foreign operations. These unrealized gains were partially offset by net unrealized pre-tax losses of $194 million and $102 million, respectively, related to derivative and nonderivative instruments designated as hedges of the foreign currency exposure during these same periods. These unrealized gains and losses were recorded as components of accumulated OCI.
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