TD Bank 2002 Annual Report Download - page 30

Management’s Discussion and Analysis of Operating Performance
28
HOW WE PERFORMED IN 2002
•Sales. We provide a wide variety of financial products to meet
the needs of our clients. We earn money on these products
from price mark-ups or commissions. Profitability is driven by
sales volume.
•Arbitrage. We take positions in certain markets or products and
offset the risk in other markets or products. Our knowledge of
various markets and products and how they relate to each
other allows us to identify and benefit from pricing anomalies.
•Positioning. We aim to make profits by taking positions in
certain financial markets in anticipation of changes in those
markets. This is the riskiest of our trading activities and we
use it selectively.
Who manages market risk
TD Securities has primary accountability for managing market
risk while the Market Risk Group within Group Risk
Management oversees market risk management. The Market
Risk Group is not accountable for trading revenues. Its
responsibilities include:
•designing and implementing methods for measuring and
reporting market risk.
•approving new or additional trading limits.
•maintaining the Market Risk Policy Manual, which contains
all policies relating to market risk in the trading businesses.
•monitoring exposure and approving any excesses compared
with the approved limits.
•approving all new trading products from a market risk
perspective.
•independent testing of all pricing models and trading systems.
•approving all market rates and prices used in valuing TD’s
trading positions and estimating market risk.
•stress testing the portfolio to determine the effect of large,
unusual market movements.
•implementing and maintaining the models used to calculate
regulatory capital required for market risk.
The Market Risk Group has established a Market Risk
Committee that meets every two weeks for a peer review of the
market risk profile of our trading businesses and to approve
changes to risk policies. The committee is chaired by the Senior
Vice President, Market Risk and includes members of senior
management of TD Securities and Internal Audit. Significant
market risk issues may be escalated to the Credit and Market
Risk Committee, which is chaired by TD’s CEO and includes
senior management of TD Securities and the Vice Chair, Group
Risk Management. The Risk Committee of the Board of Directors
reviews market risk quarterly and approves all major market risk
policies annually.
How we manage market risk
Managing market risk is a key part of our business planning
process. We begin new trading operations and expand existing
ones only if:
•the risk has been thoroughly assessed and is judged to be
within our risk capacity and business expertise.
•we have the infrastructure in place to monitor, control and
manage the risk.
We manage market risk primarily by enforcing trading limits
and by “stress testing” our trading activities.
Trading limits
Value at Risk (VaR) measures the adverse impact that potential
changes in market rates and prices could have on the value of a
portfolio over a specified period of time.
We set trading limits that are consistent with the approved
business plan for each business and our tolerance for the
market risk of that business. When setting these limits, we
consider market volatility, market liquidity, trader experience
and business strategy.
Our primary measure for setting trading limits is VaR. We use
VaR to monitor and control overall risk levels and to calculate
the regulatory capital required.
We may also apply specialized limits, such as notional limits,
credit spread limits, yield curve shift limits, loss exposure limits,
stop loss limits and other limits, if it is appropriate to do so.
These additional limits reduce the likelihood that trading losses
will exceed VaR limits.
At the end of every day, Group Risk Management reviews
daily trading exposure reports and compares the risks with their
limits. If a trading limit has been exceeded, the trading desk
must immediately bring the position within the limit, unless Group
Risk Management or a designated business head approves an
exception. An escalation process has been established for
approving exceptions to established limits.
If, during the day, it appears that a trading limit will be
exceeded, the trader must receive approval before carrying the
position overnight.
Calculating VaR
First we estimate VaR by creating a distribution of potential
changes in the market value of the current portfolio. We value
the current portfolio using the most recent 259 trading days of
market price and rate changes. Then we calculate the VaR as the
threshold level which potential portfolio losses are not expected
to exceed more than one out of every 100 trading days.
The graph below compares net revenues in our trading
businesses to daily VaR usage. Our VaR on October 31, 2002
was $14.6 million, down $7.9 million from October 31, 2001.
The average VaR for fiscal year 2002 was $17.7 million.
Declines in the VaR during fiscal 2002 are due mainly to a
better balance of risks in our credit derivative businesses, and
to improvements to our VaR methodology and process. From
May 1, 2002, net trading revenue excludes the impact of any
individual transaction with deal origination revenue in excess
of $10 million.
Net trading related revenue vs. Value at Risk
(millions of dollars)
$40
30
20
10
0
-10
-20
-30
-40
Oct. 31/02Jul. 31/02Apr. 30/02Jan. 31/02Nov. 1/01
Actual revenue
Value at Risk