Bank of Montreal 2004 Annual Report Download - page 102

BMO Financial Group Annual Report 200498
Notes to Consolidated Financial Statements
Notes
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
purchaser for accepting market risk.
For options purchased by us, we pay a premium 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 an over-the-counter contract fails to fulfill
the conditions of the contract.
Caps, collars and floors are specialized types of written and pur-
chased options. They are contractual agreements where the writer
agrees to pay the purchaser, based on a specified notional amount,
the 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
transacted to generate trading income from our own proprietary
trading positions and derivatives that do not qualify as hedges
for accounting purposes (“economic hedges”).
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 gener-
ating 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 in
our Consolidated Statement of Income. 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 as derivative financial instrument assets
and unrealized losses are recorded as derivative financial instru-
ment liabilities in our Consolidated Balance Sheet.
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, primarily using quantitative
statistical measures of correlation. If a hedge relationship is found
to be no longer effective, or 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 deriv-
atives 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.
Cash flow hedges modify exposure to variability in cash flows
for variable rate interest bearing instruments. Our cash flow hedges,
which have a maximum term of 10 years, are primarily hedges
of floating rate deposits as well as commercial and personal loans.
Swaps and options that qualify for hedge accounting are accounted
for on an accrual basis. Interest income received and interest
expense paid on interest rate swaps are accrued and recorded as
an adjustment to the yield of the item being hedged over the term
of the hedge contract. Premiums paid on purchased options
are amortized to interest expense over the term of the contract.
Accrued interest receivable and payable and deferred gains and
losses are recorded as derivative financial instrument assets
or liabilities in our Consolidated Balance Sheet, as appropriate.
Realized gains and losses from the settlement or early termination
of hedge contracts or a hedging relationship are deferred and
amortized over the remaining original life of the hedged item.
Foreign Currency Risk
We manage foreign currency risk through cross-currency swaps.
Cross-currency swaps are marked to market, with realized and
unrealized gains and losses recorded in non-interest revenue,
consistent with the accounting treatment for gains and losses on
the economically hedged item.
We also periodically hedge U.S. dollar earnings through
forward foreign exchange contracts to minimize fluctuations in
our Canadian dollar earnings due to the translation of our U.S.
dollar earnings. These contracts are marked to market, with
gains and losses recorded as non-interest revenue in foreign
exchange, other than trading.
Change in Accounting Policy
On November 1, 2002, we adopted the Canadian Institute of
Chartered Accountants’ new accounting requirements for deriva-
tives under which all derivatives are marked to market unless
they meet the criteria for hedging. There is no impact on our results
for the years ended October 31, 2004 and 2003, as we changed our
hedge criteria for derivatives when the equivalent requirements
were implemented under United States GAAP on November 1, 2000.
Fair Value
Fair value represents point-in-time estimates that may change in
subsequent reporting periods due to market conditions or other
factors. Fair value for exchange-traded derivatives is considered to
be the price quoted on derivatives exchanges. Fair value for over-
the-counter derivatives is determined using zero coupon valuation
techniques. Zero coupon curves are created using generally
accepted valuation techniques from underlying instruments such
as cash, bonds, futures and off-balance sheet prices observable
in the market. Option implied volatilities, an input into the valuation
model, are either obtained directly from market sources or calcu-
lated from market prices.