Bank of Montreal 1999 Annual Report Download - page 97

Bank of Montreal Group of Companies 1999 Annual Report 91
Note 21 Derivative Financial Instruments
We enter into interest rate, foreign exchange, equity and commodity con-
tracts to enable customers to manage risk, and for asset/liability manage-
ment
purposes where we manage our on- and off-balance sheet positions.
Customer trading derivative transactions are comprised of sales
and other activities. Sales activities include the structuring and
marketing of derivative products to customers to enable them to
transfer, modify or reduce current or expected risks. Other activ-
ities include market-making, positioning and arbitrage activities.
Market-making involves quoting bid and offer prices to other
market participants with the intention of generating revenues
based on spread and volume. Positioning involves managing
market risk positions with the expectation of profiting from
favourable movements in prices, rates or indices. Arbitrage
activities involve identifying and profiting from price differen-
tials between markets and products.
Customer trading derivatives are marked to market. Realized and unreal-
ized 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 deriva-
tives are recorded in other assets and unrealized losses are recorded in
other liabilities.
Asset/liability management derivatives are those instruments that are
designated and documented as effective as hedges. We use these instru-
ments to manage exposures in accordance with our risk management
strategy. 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 recognition
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. Premiums on purchased options
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 appropriate. Realized gains and losses from the settle-
ment or the early termination of contracts are deferred and amortized
over the remaining life of the hedging instrument. Subsequent changes
in the fair value of instruments identified as hedges, but which are no
longer effective as hedges, are redesignated as customer trading and are
reported in other income.
Derivatives transactions, which are conducted in the over-the-
counter market directly between two counterparties or on regu-
lated exchange markets, include:
Swaps
Swaps are contractual agreements between two parties to ex-
change a series of cash flows.
For interest rate swaps, counterparties generally exchange
fixed and floating rate interest payments based on a notional
value in a single currency. The main risks associated with these
instruments are the exposure to movements in interest rates and
the ability of the counterparties to meet the terms of the contract.
Interest rate swaps are used to adjust exposure to interest rate
risk by modifying the repricing or maturity characteristics of
assets and liabilities.
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.
For commodity swaps, counterparties generally exchange
fixed and floating rate payments based on a notional value in a
single commodity.
Forwards and futures
Forwards and futures are contractual agreements to either buy
or sell a specified currency, commodity 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. Risks arise from the possible
inability of over-the-counter counterparties to meet the terms of
their contracts and from movements in securities values, interest
rates and foreign exchange rates.
We periodically use forward exchange contracts to hedge con-
tractualU.S.dollarrevenuestominimizefluctuationsinU.S.dollar
earnings. These forward exchange contracts mature monthly as
related revenues are recognized. The unrecognized gain associ-
ated with these forward contracts was $5.9 as at October 31, 1999
and the unrecognized loss was $0.3 as at October 31, 1998.
Options
Options are contractual agreements that convey the right but not
the obligation to either buy or sell a specific amount of a currency,
commodity or 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 pur-
chaser for accepting market risk. For options purchased by us, a
premium is paid for the right to exercise the option, but we sus-
tain 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 mar-
ket 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 deal-
ing in both on- and off-balance sheet positions, including deriva-
tives, which are marked to market. The revenue generated by
these units is disclosed on page 31 of our Management Analysis
of Operations.
Losses incurred on defaults of counterparties charged to the
allowance for credit losses in the years ended October 31, 1999,
1998 and 1997 were not significant.
The effect of asset/liability management derivatives on net inter-
est
income and the net amount of deferred realized losses was:
1999 1998 1997
Asset/Liability Management Derivatives
Increase (decrease) in net interest income $ 27 $37 $89
Deferred realized (losses) $ (1) $ (15) $ (14)
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 mar-
ket
rates, all contracts which have a positive fair value, in effect
the unrealized gains. Derivative instruments transacted through
exchanges are subject to daily margin requirements. Such instru-
ments
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, when we have a legally enforce-
able
right to offset and intend either to settle on a net basis or to
realize the asset and settle the liability simultaneously.