Bank of Montreal 2012 Annual Report Download - page 144

Notes
Cross-currency swaps – fixed rate 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 different currencies.
Commodity swaps – counterparties generally exchange fixed and
floating rate payments based on a notional value of a single commodity.
Equity swaps – counterparties exchange the return on an equity
security or a group of equity securities for the return based on a fixed or
floating interest rate or the return on another equity security or group of
equity securities.
Credit default swaps – one counterparty pays the other a fee in
exchange for that other counterparty agreeing to make a payment if a
credit event occurs, such as bankruptcy or failure to pay.
Total return swaps – one counterparty agrees to pay or receive from
the other cash amounts based on changes in the value of a reference
asset or group of assets, including any returns such as interest earned
on these assets, in exchange for amounts that are based on prevailing
market funding rates.
The main risks associated with these instruments are related to
exposure to movements in interest rates, foreign exchange rates, credit
quality, securities values or commodities prices, as applicable, and the
possible inability 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, interest-rate-sensitive
financial instrument 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.
The main risks associated with these instruments arise from the
possible inability of over-the-counter counterparties to meet the terms
of the contracts and from movements in commodities prices, securities
values, interest rates and foreign exchange rates, as applicable.
Options
Options are contractual agreements that convey to the purchaser the
right but not the obligation to either buy or sell a specified amount of a
currency, commodity, interest-rate-sensitive financial instrument 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 meet the terms of the contract.
Caps, collars and floors are specialized types of written and
purchased options. They are contractual agreements in which 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.
Use of Derivatives
Trading Derivatives
Trading derivatives include derivatives entered into with customers to
accommodate their risk management needs, derivatives transacted to
generate trading income from our own proprietary trading positions and
certain derivatives that do not qualify as hedges for accounting purposes
(“economic hedges”).
We structure and market derivative products to enable customers 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
market instruments and derivatives that, taken together, are designed
to profit from anticipated changes in market conditions.
Trading derivatives are marked to fair value. Realized and
unrealized gains and losses are recorded in trading revenues (losses) in
our Consolidated Statement of Income. Unrealized gains on trading
derivatives are recorded as derivative instrument assets and unrealized
losses are recorded as derivative instrument 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.
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, forecasted transaction or firm commitment, or a specific
pool of transactions with similar risk characteristics.
Foreign Currency Risk
We manage foreign currency risk through cross-currency swaps and
forward contracts. These derivatives 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. Changes in fair value on forward contracts
that qualify as accounting hedges are recorded in other comprehensive
income, with the spot/forward differential (the difference between the
foreign currency rate at inception of the contract and the rate at the end
of the contract) being recorded in interest expense over the term of
the hedge.
We also sometimes economically 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 fair value, with gains and losses recorded
as non-interest revenue in foreign exchange, other than trading.
Accounting Hedges
In order for a derivative to qualify as an accounting hedge, the hedging
relationship 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 its 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 caused by the
risk being hedged or changes in the amount of the future cash flows.
Hedge effectiveness is evaluated at the inception of the hedging
relationship and on an ongoing basis, retrospectively and prospectively,
primarily using quantitative statistical measures of correlation. Any
ineffectiveness in the hedging relationship is recognized in non-interest
revenue, other, in our Consolidated Statement of Income as it arises.
Cash Flow Hedges
Cash flow hedges modify exposure to variability in cash flows for
variable rate interest bearing instruments and assets and liabilities
denominated in foreign currencies. Our cash flow hedges, which have a
maximum remaining term to maturity of six years, are hedges of
floating rate loans and deposits as well as assets and liabilities
denominated in foreign currencies.
BMO Financial Group 195th Annual Report 2012 141