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BMO Financial Group 186th Annual Report 2003 49
Accord. For capital calculation purposes, longer holding periods
and/or higher confidence levels are used than are employed for
day-to-day risk management. Models used to determine EV
exposures are the same as or similar to those used to determine
VaR exposures.
Market risk exposures arising from trading and underwriting
activities are summarized in the following table.
Total Trading and Underwriting VaR Summary ($ millions)*
For the year ended October 31, 2003
(Pre-tax Canadian equivalent) Year-end Average High Low
Interest rate 17.6 16.4 25.5 10.8
Credit spread 3.8 4.5 8.4 2.0
Foreign exchange 6.3 5.0 10.8 2.8
Commodity 0.8 1.2 2.6 0.5
Equity 5.1 5.0 14.1 2.4
Correlation effect (5.4) (5.5) na na
Total 28.1 26.6 37.6 18.1
*One-day measure using a 99% confidence level. na
–
not applicable
In determining VaR, we take only partial account of the correla-
tion and offsets that may exist between certain portfolios and
classes of risk, such as equity prices and interest rates. A more
conservative measure of market risk is therefore calculated than
would otherwise be the case.
BMO has not experienced a loss this year that exceeded the
overall VaR measure in the trading and underwriting portfolios,
as can be seen in the following diagram. The $35 million of daily
trading revenue reflected in the adjacent graphs substantially
relates to commodity derivatives trading revenue, as explained
on page 24.
Trading r evenues include amounts from all trading and under-
writing activities, whether accounted for on a mark-to-market
basis or an accrual basis, and also include certain fees and com-
missions directly related to those activities.
We monitor the application of our models to ensure that they
are appropriate to the particular portfolio to which they are
applied, and we take corrective action, including making adjust-
ments to the determination of daily net trading revenues, when
model limitations are identified.
We use a variety of methods to ensure the integrity of these
models, including the application of backtesting against hypo-
thetical losses. This process assumes there are no changes in the
previous day’s closing positions. The process then isolates the
effects of each day’s price movements against these closing
positions. Models are considered to be validated by such testing
if, on average, calculated hypothetical losses exceed the VaR
measure only one time out of 100. Results of this testing confirm
the reliability of our models.
The models used to measure market risks are effective at
measuring risks under normal market conditions. In addition,
we perform scenario analysis and stress testing to determine
the impact of unusual and/or unexpected market changes on our
portfolios. We use a comprehensive set of scenarios and stress
tests, and the results are reported to RMC and RRC on a regular
basis. For trading and underwriting portfolios, exposures are
required to be managed within pre-set stress limits.
Structural Market Risk
Structural market risk is comprised of interest rate risk arising
from our structural banking activities (loans and deposits), and
foreign exchange risk arising from our foreign currency oper-
ations. BMO’s Corporate Treasury manages structural market
risk in support of stable, high-quality earnings.
Structural interest rate risk arises primarily from interest rate
mismatches and embedded options. Interest rate mismatches
result from differences in the scheduled maturity or repricing
dates of assets, liabilities and off-balance sheet items. Embedded
option risk results from product features that allow customers to
modify scheduled maturity or repricing dates. Embedded options
include loan prepayment and deposit redemption privileges and
committed rates on unadvanced mortgages. The net interest
rate mismatch, representing residual assets funded by common
–40
–30
–20
–10
0
10
20
30
40
Trading and Underwriting
Revenue versus Value at Risk
November 1, 2002 to October 31, 2003 ($ millions)
Revenue Total mark-to-market and accrual riskMark-to-market risk
Jan 31
Nov 1
Jul 31
Oct 31
Apr 30
0
10
20
30
40
50
353025201514131211109876543210(1)(2)(3)
Frequency Distribution of Daily Revenue for Trading and Underwriting,
Money Market and Accrual Portfolios
November 1, 2002 to October 31, 2003
Daily net revenues ($ millions)
Number of days
We also measure exposure to concentrations of market risk, such
as changes in particular interest rates, foreign exchange rates,
equity or commodity prices and their related implied volatilities.
Effective controls over the revaluation of trading and under-
writing portfolios and the determination of daily revenue from
these activities enable us to monitor the revenue generated by
each of the lines of business in relation to their business strate-
gies and their level of market risk.