Bank of Montreal 2012 Annual Report Download - page 173

Notes
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(e) Other Commitments
As a participant in merchant banking activities, we enter into
commitments to fund external private equity funds and investments in
equity and debt securities at market value at the time the commitments
are drawn. In addition, we act as underwriter for certain new issuances
under which we alone or together with a syndicate of financial
institutions purchase the new issue for resale to investors. In connection
with these activities, as at October 31, 2012 our related commitments
were $3,280 million ($2,074 million in 2011).
Note 29: Fair Value of Financial Instruments
We record trading assets and liabilities, derivatives, available-for-sale
securities and securities sold but not yet purchased at fair value, and
other non-trading assets and liabilities at amortized cost less allowances
or write-downs for impairment. Where there is no quoted market price,
fair value is determined using a variety of valuation techniques and
assumptions. These fair values are based upon the estimated amounts
for individual assets and liabilities and do not include an estimate of the
fair value of any of the legal entities or underlying operations that
comprise our business.
Fair value amounts disclosed represent point-in-time estimates that
may change in subsequent reporting periods due to market conditions or
other factors. Fair value represents our estimate of the amounts for which
we could exchange the financial instruments with willing third parties who
were interested in acquiring the instruments. Some of the financial
instruments are not typically exchangeable or exchanged and therefore it
is difficult to determine their fair value. We calculate fair value using
management’s best estimates based on a range of methodologies and
assumptions; since they involve uncertainties, the fair values may not be
realized in an actual sale or immediate settlement of the instruments.
Financial Instruments Whose Book Value
Approximates Fair Value
Fair value is assumed to equal book value for acceptance-related
liabilities, due to the short-term nature of these assets and liabilities.
Fair value is also assumed to equal book value for our cash resources,
certain other assets and certain other liabilities.
Securities
For traded securities, quoted market value is considered to be fair value.
Quoted market value is based on bid prices. Securities for which no
active market exists are valued using all reasonably available market
information. Our fair value methodologies are described below.
Government Securities
The fair value of government issued or guaranteed debt securities in
active markets is determined by reference to recent transaction prices,
broker quotes, or third-party vendor prices. The fair value of securities
that are not traded in an active market are modelled using implied
yields derived from the prices of actively traded similar government
securities and observable spreads. Market inputs to the model include
coupon, maturity and duration.
Mortgage-Backed Securities and Collateralized Mortgage Obligations
The fair value of mortgage-backed securities and collateralized
mortgage obligations is determined by obtaining independent prices
provided by third-party vendors, broker quotes and relevant market
indices, as applicable. If independent prices are not available, fair value
is determined using cash flow models that make maximum use of
market observable inputs or benchmark prices to similar instruments.
Mortgage-backed security assumptions include the discount rate,
expected prepayments, credit spreads, defaults and recoveries.
Collateralized mortgage obligation assumptions include expected
prepayment, default and recovery.
Corporate Debt Securities
The fair value of corporate debt securities is determined using the most
recently executed transaction prices. When observable price quotations
are not available, fair value is determined based on discounted cash
flow models using discounting curves and spreads observed through
independent dealers, brokers, and multi-contributor pricing sources.
Corporate Equity Securities
The fair value of equity securities is based on quoted prices in active
markets, where available. Where quoted prices in active markets are
not readily available, fair value is determined based on quoted market
prices for similar securities or through valuation techniques, including
discounted cash flow analysis and multiples of earnings.
Privately Issued Securities
Privately issued debt and equity securities are valued using recent
market transactions, where available. Otherwise, fair values are derived
from valuation models using a market or income approach. These
models consider various factors including projected cash flows, earnings,
revenue and other third-party evidence as available. The fair value of
limited partnership investments is based upon net asset values
published by third-party fund managers.
Prices from brokers and multi contributor pricing sources are
corroborated as part of our independent review process, which may
include using valuation techniques or obtaining consensus or composite
prices from other pricing services. We validate that the estimates of fair
value are reasonable by independently obtaining multiple quotes of
external market prices and values of inputs. We review the approach
taken by third-party vendors by ensuring that the vendor employs a
valuation model which maximizes the use of observable inputs such as
benchmark yields, bid-ask spreads, underlying collateral, weighted
average terms to maturity and prepayment rate assumptions. Fair value
estimates from internal valuation techniques are verified, where
possible, to prices obtained from third-party vendors.
Loans
In determining the fair value of our fixed rate and floating rate
performing loans and customers’ liability under acceptances, we
discount the remaining contractual cash flows, adjusted for estimated
prepayment, at market interest rates currently offered for loans with
similar terms.
The value of our loan balances determined using the above
assumption is further adjusted by a credit mark that represents an
estimate of the expected credit losses in our loan portfolio.
Derivative Instruments
A number of well established valuation techniques are employed to
estimate fair value, including discounted cash flow analysis, the Black-
Scholes model, Monte Carlo simulation and other accepted market
models. These vetted models incorporate current market measures for
interest rates, currency exchange rates, equity and commodity prices
and indices, credit spreads, recovery rates, corresponding market
volatility levels, spot prices, correlation levels and other market-based
pricing factors. Option implied volatilities, an input into many valuation
models, are either obtained directly from market sources or calculated
from market prices. Multi-contributor pricing sources are used
wherever possible.
170 BMO Financial Group 195th Annual Report 2012