Bank of Montreal 2010 Annual Report Download - page 137

Notes
BMO Financial Group 193rd Annual Report 2010 135
Derivative-Related Market Risk
Derivative instruments are subject to market risk. Market risk arises
from the potential for a negative impact on the balance sheet and/or
income statement resulting from adverse changes in the value of
derivative instruments as a result of changes in certain market variables.
These variables include interest rates, foreign exchange rates, equity and
commodity prices and their implied volatilities, as well as credit spreads,
credit migration and default. We strive to limit market risk by employing
comprehensive governance and management processes for all market
risk-taking activities.
Derivative-Related Credit Risk
Over-the-counter derivative instruments are subject to credit risk
arising from the possibility that counterparties may default on their
obligations. The credit risk associated with derivatives is normally
a small fraction of the notional amount of the derivative instrument.
Derivative contracts generally expose us to potential credit loss if
changes in market rates affect a counterparty’s position unfavourably
and the counterparty defaults on payment. The credit risk is
represented by the positive fair value of the derivative instrument.
We strive to limit credit risk by dealing with counterparties that we
believe are creditworthy, and we manage our credit risk for derivatives
using the same credit risk process that is applied to loans and other
credit assets.
(Canadian $ in millions) 2010 2009
Replacement Credit risk Risk-weighted Replacement Credit risk Risk-weighted
cost equivalent assets cost equivalent assets
Interest Rate Contracts
Swaps 32,613 38,255 – 28,122 33,730 –
Forward rate agreements 87 110 – 231 239 –
Purchased options 1,379 1,566 – 1,710 1,945 –
Total interest rate contracts 34,079 39,931 3,738 30,063 35,914 3,631
Foreign Exchange Contracts
Cross-currency swaps 1,271 2,456 – 1,542 2,994 –
Cross-currency interest rate swaps 4,595 13,087 – 3,662 11,441 –
Forward foreign exchange contracts 4,050 6,702 – 3,948 6,695 –
Purchased options 173 245 – 171 284 –
Total foreign exchange contracts 10,089 22,490 2,477 9,323 21,414 2,340
Commodity Contracts
Swaps 1,462 3,612 – 1,500 4,915 –
Purchased options 382 1,666 – 829 2,855 –
Total commodity contracts 1,844 5,278 853 2,329 7,770 1,232
Equity Contracts 625 1,961 137 1,365 1,945 235
Credit Default Swaps 1,280 1,756 3,476 2,937 3,188 3,401
Total derivatives 47,917 71,416 10,681 46,017 70,231 10,839
Less: impact of master netting agreements (31,537) (45,706) – (29,423) (42,581) –
Total 16,380 25,710 10,681 16,594 27,650 10,839
The total derivatives and impact of master netting agreements for replacement cost do not include exchange-traded derivatives with a fair value of $1,842 million as at October 31, 2010 ($1,881 million in 2009).
Transactions are conducted with counterparties in various geographic locations and industries. Set out below is the replacement cost of contracts
(before the impact of master netting agreements) with customers located in the following countries, based on country of ultimate risk:
(Canadian $ in millions, except as noted) 2010 2009
Canada 19,202 40% 19,640 43%
United States 12,450 26 11,783 26
United Kingdom 7,363 15 6,699 14
Other countries (1) 8,902 19 7,895 17
Total 47,917 100% 46,017 100%
(1) No other country represented 10% or more of our replacement cost in 2010 or 2009.
We also pursue opportunities to reduce our exposure to credit
losses on derivative instruments, including entering into collateral agree-
ments and entering into master netting agreements with counter parties.
The credit risk associated with favourable contracts is eliminated by
master netting agreements to the extent that unfavourable contracts with
the same counterparty cannot be settled before favourable contracts.
Exchange-traded derivatives have no potential for credit exposure
as they are settled net with each exchange.
Terms used in the credit risk table below are as follows:
Replacement cost represents the cost of replacing all contracts that
have a positive fair value, using current market rates. It represents
in effect the unrealized gains on our derivative instruments. Replacement
costs disclosed below represent the net of the asset and liability to a
specific counterparty where we have a legally enforceable right to offset
the amount owed to us with the amount owed by us and we intend
either to settle on a net basis or to realize the asset and settle the
liability simultaneously.
Credit risk equivalent represents the total replacement cost plus
an amount representing the potential future credit exposure, as outlined
in OSFI’s Capital Adequacy Guideline.
Risk-weighted assets represent the credit risk equivalent, weighted
based on the creditworthiness of the counterparty, as prescribed by OSFI.