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BMO Financial Group Annual Report 2004 63
MD&A
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 con-
firm 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 MRC, RMC and RRC
on a regular basis.
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
operations. Structural market risk is managed by BMO’s
Corporate Treasury in support of stable, high-quality earnings.
Structural interest rate risk arises primarily from interest
rate mismatches and embedded options. Interest rate mis-
matches 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 shareholders’ equity, is
maintained at a target duration of between two and three
years and embedded options are managed to low risk levels.
The interest rate mismatch is primarily managed with interest
rate swaps and securities. Embedded option exposures
are managed by purchasing options or through a dynamic
hedging process.
Structural foreign exchange risk arises primarily from
translation risk associated with the net investment in our U.S.
operations, and from transaction risk associated with our
U.S. dollar net income. Translation risk is managed by funding
our net U.S. investment in U.S. dollars. Transaction risk is
managed by entering into foreign exchange forward contract
hedges each quarter that are expected to partially offset the
effects of Canadian/U.S. dollar exchange rate fluctuations on
the quarter’s net income. The impact of exchange rate fluc-
tuations on BMO’s 2004 net income is reviewed on page 27.
Structural MVE and EV measures both reflect holding
periods of between one and three months and incorporate the
impact of correlations between market variables. Structural
MVE (see page 62) increased modestly over the past year due to
growth in common shareholders’ equity, while EV continues
to be managed to low levels.
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
strategies and their level of market risk.
–35
–25
–15
–5
5
15
25
Trading and Underwriting Net Revenues versus Value at Risk
November 1, 2003 to October 31, 2004 ($ millions)
Revenue Total mark-to-market and accrual riskMark-to-market risk
Jan 31
Nov 1
Jul 31
Oct 31
Apr 30
BMO did not experience a loss in 2004 in the trading and underwriting
portfolios that exceeded the overall VaR measure.
Trading revenues 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
commissions 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
adjustments to the determination of daily net trading revenues,
when model limitations are identified.
0
10
20
30
40
50
60
2120191817161514131211109876543210(1)(2)(3)(4)(5)
Frequency Distribution of Daily Net Revenues for Trading
and Underwriting, Money Market and Accrual Portfolios
November 1, 2003 to October 31, 2004
Daily net revenues ($ millions)
Frequency in number of days
The distribution of our daily net revenue for the portfolios reflects the broad
diversification of risk in our trading activities, designed to reduce the volatility
of daily net revenues. There were two occasions in 2004 when unusually
favourable market conditions contributed to particularly high daily net revenue.