Bank of Montreal 1997 Annual Report Download - page 89

Bank of Montreal 180th Annual Report 1997 83
We enter into interest rate, foreign exchange, equity and commodity con-
tracts, forwards, futures, options and swaps to enable customers to manage
risk, and for proprietary trading and asset/liability management purposes.
Trading derivatives are those derivatives which we undertake in order
to assist customers in managing their exposures and to generate income
from proprietary trading positions. Trading derivatives are marked to mar-
ket. Realized and unrealized gains and losses are recorded in other income.
A portion of the income derived from marking derivatives to market in
respect of credit risk premiums and administrative costs is deferred and
amortized to income over the life of the contracts. Unrealized gains
on trading derivatives are recorded in other assets and unrealized losses
are recorded in other liabilities.
Asset/liability management derivatives are those which we use to
manage the interest rate and foreign exchange exposures arising from our
on-balance sheet positions. Such derivatives include contracts which are
designated and effective as hedges. For a hedge to be effective, changes in
the market value of the derivative must be highly correlated with changes
in the market value of the underlying hedged item at inception and over the
life of the hedge. Swaps, forwards and options, which are used for such
purposes, are accounted for on the accrual basis, under which income and
expense from the derivative instrument is accrued and there is no recogni-
tion of unrealized gains and losses on the derivative in the balance sheet.
For swaps and forwards, interest income and expense from the hedging
instrument is accrued and recorded as an adjustment to the income
or expense related to the hedged position. Option premiums are amortized
over the life of the contract to the income or expense line associated with
the hedged position. Accrued interest receivable and payable and deferred
gains and losses are recorded in other assets or other liabilities as appro-
priate. Realized gains and losses from the settlement of futures and inter-
est rate forwards and from the early termination of all types of contracts are
deferred and amortized over the remaining life of the hedging instrument.
Subsequent changes in fair value of instruments identified as hedges but
which are no longer effective as hedges are reported in other income.
Derivatives transactions, which are conducted in the over-
the-counter market directly between two counterparties or
on regulated exchange markets, include:
Swaps, which are contractual agreements between two parties to
exchange a series of cash flows. For interest rate swaps, counter-
parties generally exchange fixed and floating rate interest payments
based on a notional value in a single currency. For cross-currency
swaps, fixed interest payments and notional amounts are exchanged
in different currencies. For cross-currency interest rate swaps,
principal amounts and fixed and floating interest payments are
exchanged in different currencies.
Forwards and futures, which are contractual agreements to
either buy or sell a specified currency or financial instrument at a
specific price and date in the future. Forwards are customized
contracts transacted in the over-the-counter market. Futures are
transacted in standardized amounts on regulated exchanges and
are subject to daily cash margining.
Options, which are contractual agreements that convey the right
but not the obligation to either buy or sell a specific amount of a
financial instrument at a fixed price either at a fixed future date
or at any time within a fixed future period.
For options written by us, we receive a premium from the
purchaser for accepting position risk. For options purchased by
us, a premium is paid for the right to exercise the option, but we
sustain credit risk due to the uncertainty as to the writer’s ability
to fulfill the conditions of the contract. Also included in options
are caps, collars and floors, which are contractual agreements
where the writer agrees to pay the purchaser, based on a specified
notional amount, the agreed upon difference between the market
rate and the prescribed rate of the cap, collar or floor. The writer
receives a premium for selling this instrument.
We conduct our trading activities through business units
dealing in both on and off-balance sheet positions, including
derivatives, which are marked to market. The revenue generated
by these units is disclosed on page 26 of the Management
Analysis of Operations.
Losses incurred on defaults of counterparties charged to the
allowance for credit losses in the years ended October 31, 1997
and 1996 were not significant.
The effect of asset/liability management derivatives on net
interest income and the amount of deferred gains/losses on such
contracts was:
1997 1996 1995
Asset/Liability Management Derivatives
Increase (decrease) in net interest income $ 89 $ 33 $ (29)
Deferred realized (losses) $ (14) $(3) $ (6)
The following table summarizes our derivative portfolio and
related credit exposure:
Notional amount: represents the amount to which a rate or price
is applied in order to calculate the exchange of cash flows.
Replacement cost: represents the cost of replacing, at current
market rates, all contracts which have a positive fair value,
in effect the unrealized gain. Derivative instruments transacted
through exchanges are subject to daily margin requirements.
Such instruments are excluded from the calculation of risk-
weighted assets as they are deemed to have no additional credit
risk. The amounts take into consideration offsetting, where we
have a legally enforceable right to offset and intend either to
settle on a net basis, or to realize the asset and settle the liability
simultaneously.
Credit risk equivalent: represents the total replacement cost
and potential future credit exposure, taking into consideration
offsetting as permitted by the Superintendent of Financial
Institutions Canada.
Risk-weighted balance: represents the credit risk equiva-
lent, weighted according to the creditworthiness of the
counterparty, as prescribed by the Superintendent of Financial
Institutions Canada.
Note 20 Derivative Financial Instruments
securities sold but not yet purchased, securities sold under repur-
chase agreements and other secured liabilities. Additionally,
we had deposit assets in the amount of $317 as at October 31, 1997
(1996 – $213) to act as security for our participation in clearing
and payment systems and as security for contract settlements
with derivatives exchanges or other derivative counterparties.
(e) Cash Restrictions
Some of our subsidiaries are required to maintain reserves
or minimum balances with central banks in their respective
countries of operation. Cash resources included $398
as at October 31, 1997 and $266 as at October 31, 1996 of
these balances.