DERIVATIVE INSTRUMENTS The Company enters into interest rate swap agreements in order to manage interest rate exposure. In most cases, this exposure is related to the funding of fixed rate assets with floating rate obligations, including off-balance sheet securitizations. The Company also enters into forward foreign currency exchange contracts and cross currency swaps to reduce sensitivity to changing foreign currency exchange rates. The hedging of foreign currency exchange rates is limited to certain intercompany obligations related to international operations. These derivatives expose the Company to certain credit risks. The Company has established policies and limits, as well as collateral agreements, to manage credit risk related to derivative instruments. Additional information regarding derivative instruments can be found in Note S to the Consolidated Financial Statements. Risk is an inherent part of the Company’s business and activities. The Company’s ability to properly and effectively identify, assess, monitor and manage risk in its business activities is critical to its safe and sound operation and profitability. The Company’s business activities generate credit risk, liquidity risk, interest rate risk and operational risk, each of which is described below. Credit risk is one of the Company’s most important risk categories. Consequently, as part of the Company’s risk management process, stronger central control of credit policies and programs has been established, while maintaining the ability of the Company’s operating units to respond flexibly to changing market and competitive conditions. In 2002, the Company appointed a dedicated Chief Credit Officer, expanded its central Credit Risk Management staff and strengthened its Credit Policy Committee. The credit committee and staff group ensure that the Company’s credit decisions are made on a conservative basis, that each of its operating units apply best practices in measuring and managing credit risk, and that all relevant factors, including credit outlook, profitability, and the competitive, economic and regulatory environment are considered in making credit decisions. In addition to strong governance, another key element in the Company’s management of credit risk is its use of IBS. In its credit policy, the Company has identified six key principles which govern the use of IBS in credit management. These principles are: (1) Empirical Evidence - that all decisions shall be made on the basis of the best available data; (2) Inseparability - that it is impossible to separate credit decisions from product terms and marketing channels; (3) Expectation of Volatility - that the expectation that future credit performance could be worse than past credit performance should be explicitly factored into underwriting decisions; (4) Positive Net Present Value - that all prospective and existing pools of accounts need to have a positive net present value when solicited or when the terms of the loans are adjusted; (5) Earnings Stability - that a loan shall only be booked if the Company will be satisfied with the loan’s performance during each discrete period of the loan’s life; and (6) Constrained Optimization - that individual credit programs will sometimes be limited to insure that the overall portfolio and specific individual account characteristics conform to limits established by the Company and its Board of Directors. These principles are the foundation of the Company’s credit decision making approach. They govern the selection of customers, and the approach to pricing, credit line management, customer management, collections and recoveries. They provide a framework in which the Company can apply a very high degree of analytical rigor to decision making while preserving the flexibility to respond quickly to changing market and economic conditions. The Company’s credit risk profile is managed to maintain better than average credit quality, strong risk-adjusted returns and increased diversification. This is accomplished by increasing growth in the prime and superprime card business, while reducing growth in the subprime card business, by customizing credit lines and product terms to each consumer segment to ensure appropriate returns, by diversification into consumer lending, products such as automobile financing and unsecured installment lending and by international expansion. The centralized Credit Risk Management group monitors overall composition and quality of the credit portfolio. The Company takes into consideration potential future economic conditions when monitoring and assessing its credit portfolio to understand its credit risk profile under various stressful conditions. The Company’s guiding principles, strengthened central governance and Board-directed risk tolerances, ensure that senior executives are well-informed of credit trends and can make appropriate credit and business decisions for the Company. The Company ensures day-to-day market responsiveness and flexibility by empowering its business line managers to develop credit strategies and programs aligned with the objective of long-term business profitability. The credit program development process considers the evolving needs of the target market, the competitive environment and the economic outlook. It is highly analytical and uses the Company’s extensive database of past test results. Senior Credit Officers, who are appointed by the Credit Policy Committee, oversee all credit program development. Large new programs or program changes are reviewed by the Credit Policy Committee or its subcommittee. Most of the Company’s credit strategies rely heavily on the use of sophisticated proprietary scoring models. These models consider many variables, including credit scores developed by nationally recognized scoring firms. The models are validated, monitored and maintained in accordance with detailed policies and procedures to ensure their continued validity.  Interest rate risk refers to changes in earnings or the net present value of assets and off-balance sheet positions less liabilities (termed “economic value of equity”) due to interest rate changes. To the extent that managed interest income and expense do not respond equally to changes in interest rates, or that all rates do not change uniformly, earnings and economic value of equity could be affected. The Company’s managed net interest income is affected primarily by changes in LIBOR, as variable rate card receivables, securitization bonds and corporate debts are repriced. The Company manages and mitigates its interest rate sensitivity through several techniques, which include, but are not limited to, changing the maturity, repricing and distribution of assets and liabilities and by entering into interest rate swaps. Interest Rate Risk Credit Risk RISK MANAGEMENT 37