Bank of Montreal 2004 Annual Report Download - page 66

BMO Financial Group Annual Report 200462
MD&A
Management’s Discussion and Analysis
Market risk is the potential for a negative impact on the balance sheet
and/or income statement resulting from adverse changes in the value of
financial instruments as a result of changes in certain market variables.
These variables include interest rates, foreign exchange rates, equity or
commodity prices and their implied volatilities, as well as credit spreads,
credit migration and default.
Market Value Exposure (MVE) is a measure of the adverse impact of
changes in market parameters on the market value of a portfolio of
assets, liabilities and off-balance sheet positions, measured at a 99%
confidence level over a specified holding period. The holding period
considers current market conditions and composition of the portfolios to
determine how long it would take to neutralize the market risk without
adversely affecting market prices. For trading and underwriting activities,
MVE is comprised of VaR and issuer risk.
Earnings Volatility (EV) is a measure of the adverse impact of potential
changes in market parameters on the projected 12-month after-tax net
income of a portfolio of assets, liabilities and off-balance sheet positions,
measured at a 99% confidence level over a specified holding period.
Value at Risk (VaR) is measured for specific classes of risk in BMO’s
trading and underwriting activities: interest rate, currency, equity and
commodity prices and implied volatilities. This measure calculates the
maximum likely loss from portfolios, over an appropriate holding period,
measured at a 99% confidence level.
Issuer risk arises in BMO’s trading and underwriting portfolios, and
measures the adverse impact of credit spread, credit migration and
default risks on the market value of non-sovereign fixed income instru-
ments and similar securities. Issuer risk MVE is measured at a 99%
confidence level over an appropriate holding period.
Market Risk
BMO incurs market risk in its trading and underwriting activi-
ties and structural banking activities.
As part of our enterprise-wide risk management framework, we
employ comprehensive governance and management processes
surrounding market risk-taking activities. These include:
•oversight by senior governance committees, including
Market Risk Committee (MRC), RMC and RRC;
•independent market risk oversight functions;
•independent process and internal control reviews by
Corporate Audit;
•effective processes to measure market risks linked to the
allocation of economic capital and the valuation of positions;
•a well-developed limit-setting and monitoring process;
•effective controls over processes and models used; and
•
a framework of scenario and stress tests for worst-case events.
BMO’s primary market risk measures are Market Value Exposure
(MVE) and Earnings Volatility (EV). The aggregate market
value and earnings volatility exposures at October 31, 2004 are
summarized in the following table. MVE has increased modestly
relative to last year, primarily due to growth in common share-
holders’ equity in the structural balance sheet. EV exposure has
declined relative to last year due to decreased exposure in the
money market accrual portfolios and a lower risk assessment
of the mark-to-market portfolios. The decrease in mark-to-
market portfolio risk is the result of the implementation of our
Comprehensive Value at Risk model, which better reflects the
correlations between different classes of market risk.
Aggregate MVE and EV Exposure for Trading and Underwriting
and Structural Positions ($ millions)*
As at October 31 Market value 12-month
(After-tax Canadian equivalent) exposure earnings volatility
2004 2003 2004 2003
Trading and underwriting 10.0 18.0 18.0 33.4
Structural 340.2 311.6 28.0 24.8
Total 350.2 329.6 46.0 58.2
*Measured at a 99% confidence level.
Trading and Underwriting Market Risk
BMO’s trading and underwriting activities include portfolios that
are marked to market daily, as well as some portfolios (such as
money market assets) that are subject to accrual accounting
rules under generally accepted accounting principles. For these
activities, VaR measures the magnitude of BMO’s market risk.
During fiscal 2004, we implemented our Comprehensive
Value at Risk model for market risk management and reporting
of exposures in the mark-to-market trading and underwriting
portfolios. The new model better reflects the correlations
between the different classes of market risk and incorporates
methodology improvements for more complex trading prod-
ucts. At year-end, the Comprehensive VaR model had not yet
been approved for use in calculating regulatory capital.
Various VaR models are used to determine market risk capital
at risk for each of the lines of business, and are also used to
determine regulatory capital under the standards of the 1998
Basel I 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, 2004
(Pre-tax Canadian equivalent) Year-end Average High Low
Commodity VaR 1.1 1.3 3.3 0.5
Equity VaR 3.9 4.4 13.1 2.3
Foreign exchange VaR 0.5 1.4 3.8 0.1
Interest rate VaR (mark-to-market) 3.8 5.2 11.2 3.4
Correlation effect (4.6) (5.4) (8.8) (1.4)
Comprehensive VaR 4.7 6.9 14.9 4.2
Interest rate VaR (accrual) 6.3 7.5 11.9 4.3
Credit spread VaR 4.0 4.5 7.0 2.9
Total VaR 15.0 18.9 28.4 14.1
*One-day measure using a 99% confidence level.