Bank of Montreal 2003 Annual Report Download - page 86

BMO Financial Group 186th Annual Report 200382
Notes to Consolidated Financial Statements
Derivative financial instruments are contracts that require the
exchange of, or provide the opportunity to exchange, cash flows
determined by applying certain rates, indices or changes therein to
notional contract amounts. Derivative transactions are conducted
either directly between two counterparties in the over-the-counter
market, or on regulated exchange markets.
Types of Derivatives
Swaps
Swaps are contractual agreements between two parties to exchange
a series of cash flows. The various swap agreements that we enter
into are as follows:
Interest rate swaps – counterparties generally exchange fixed
and floating rate interest payments based on a notional value in a
single currency.
Cross-currency swaps – fixed interest payments and principal
amounts are exchanged in different currencies.
Cross-currency interest rate swaps – fixed and floating rate
interest payments and principal amounts are exchanged in dif-
ferent currencies.
Commodity swaps – counterparties generally exchange fixed
and floating rate payments based on a notional value in a single
commodity.
Equity swaps – counterparties exchange the return on an equity
security or group of equity securities.
Credit default swaps – one counterparty pays the other a fee in
exchange for that other counterparty making a payment if a credit
event occurs, such as bankruptcy or credit rating change.
The main risks associated with these instruments are the exposure
to movements in interest rates, foreign exchange rates, credit ratings
and securities or commodities prices, as applicable, and the ability
of counterparties to meet the terms of the contracts.
Forwards and Futures
Forwards and futures are contractual agreements to either buy
or sell a specified amount of a currency, commodity or security 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 coun-
terparties to meet the terms of their contracts and from movements
in commodities prices, securities values, interest rates and foreign
exchange rates.
Options
Options are contractual agreements that convey to the buyer the
right but not the obligation to either buy or sell a specified amount
of a currency, commodity or security 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. Since we have no obligation to exercise the
option, our primary exposure to risk is the potential credit risk if
the writer of over-the-counter contracts fails to fulfill the conditions
of the contract.
Caps, collars and floors are specialized types of written and
purchased options. They 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.
Uses of Derivatives
Trading Derivatives
Trading derivatives are derivatives entered into with customers
to accommodate their risk management needs, derivatives trans-
acted to generate trading income from the Bank’s own proprietary
trading positions and derivatives that do not qualify as hedges for
accounting purposes.
We structure and market derivative products to customers to
enable them to transfer, modify or reduce current or expected risks.
Proprietary activities 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 activities involve
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 differentials
between markets and products.
We may also take proprietary trading positions in various capital
markets instruments and derivatives that, taken together, are
designed to profit from anticipated changes in market factors.
Trading derivatives are marked to market. Realized and unrealized
gains and losses are recorded in trading revenues. A portion of
the income derived from marking derivatives to market reflects
credit, model and liquidity risks, as well as administrative costs.
An estimate of this amount is deferred and recognized in trading
revenues over the term of the derivative contract. Unrealized gains
on trading derivatives are recorded in our derivative financial
instrument asset and unrealized losses are recorded in our deriva-
tive financial instrument liability.
The revenue generated by trading derivatives is included in
trading revenue, details of which are provided on page 24 of our
Management’s Discussion and Analysis.
Hedging Derivatives
In accordance with our risk management strategy, we enter into
various derivative contracts to hedge our interest rate and foreign
currency exposures.
In order for a derivative to qualify as a hedge, the hedge relation-
ship must be designated and formally documented at its inception,
detailing the particular risk management objective and strategy for
the hedge and the specific asset, liability or cash flow being hedged,
as well as how effectiveness is being assessed. Changes in the fair
value of the derivative must be highly effective in offsetting either
changes in the fair value of on-balance sheet items or changes in
the amount of future cash flows. Hedge effectiveness is evaluated
at the inception of the hedge relationship and on an ongoing basis,
both retrospectively and prospectively, using quantitative statistical
measures of correlation. If a hedge relationship is found to be no
longer effective, the derivative is no longer designated as a hedge;
if the designated hedged item matures or is sold, extinguished or
terminated, the derivative is reclassified as trading. Subsequent
changes in the fair value of hedging derivatives reclassified as
trading are reported in trading revenues.
Risks Hedged
Interest Rate Risk
We manage interest rate risk through interest rate swaps and
options, which are linked to and adjust the interest rate sensitivity
of a specific asset, liability, firm commitment or a specific pool of
transactions with similar risk characteristics.
Fair value hedges modify exposure to changes in a fixed rate
instrument’s fair value caused by changes in interest rates. These
hedges convert fixed rate assets and liabilities to floating rate. Our
fair value hedges include hedges of fixed rate loans, securities,
deposits and subordinated debt.
Note 9 Derivative Financial Instruments