TD Bank 2002 Annual Report Download - page 32

Management’s Discussion and Analysis of Operating Performance
30
HOW WE PERFORMED IN 2002
The objective of interest rate risk management is to ensure
stable and predictable earnings are realized over time. In this
context, TD has adopted a “fully-hedged”approach to
profitability management for its asset and liability positions. Key
aspects of this approach are:
•negating the impact of interest rate risk on net interest income
and economic value.
•measuring the contribution of each product on a risk-adjusted,
fully-hedged basis, including the impact of financial options
granted to customers.
We are exposed to interest rate risk when asset and liability
principal and interest cash flows have different interest payment
or maturity dates. These are called “mismatched positions”. An
interest-sensitive asset or liability is repriced when interest rates
change or when there is cash flow from final maturity, normal
amortization or when customers exercise prepayment, con-
version or redemption options.
Our exposure depends on the size and direction of interest
rate changes, and on the size and maturity of the mismatched
positions. It is also affected by new business volumes, renewals
of loans and deposits, and how actively customers exercise
options like prepaying or redeeming a loan or deposit before its
maturity date.
Interest rate risk is measured using interest rate shock
scenarios to estimate the impact of changes in interest rates on
both TD’s annual Earnings at Risk (EaR) and Economic Value at
Risk (EVaR). EaR is defined as the change in TD’s annual net
interest income for a 100 basis point unfavourable interest rate
shock due to mismatched cash flows. EVaR is defined as the
combined difference in the present value of TD’s asset portfolio
and the change in the present value of the TD’s liability
portfolio, including off-balance sheet instruments, for a 100
basis point unfavorable interest rate shock.
We perform valuations of all asset and liability positions as
well as all off-balance sheet exposures every week, and value
certain option positions daily. Our objective is to preserve or
immunize the present value of the margin booked at the time of
inception for fixed rate assets and liabilities and to reduce the
volatility of earned net interest income over time. Our approach
is to value the assets and liabilities by discounting future cash
flows at a yield curve indicative of the blended cost or credit of
funds for each asset or liability portfolio. The resulting net
present value embeds the present value of margins booked. We
then hedge the resulting financial position to a target risk profile.
We use derivative financial instruments, wholesale instruments
and other capital market alternatives and, less frequently,
product pricing strategies to manage interest rate risk.
Within the financial position, we measure and manage
interest rate risk exposure from instruments with closed (non-
optioned) fixed rate cash flows separately from product options.
Instruments in the closed book exhibit the traditional, almost
linear or symmetrical payoff profile to parallel changes in
interest rates (i.e. asset values increase as rates fall and
decrease as rates rise). The portfolio management objective
within the closed book is to eliminate cash flow mismatches
thereby preserving the present value of product margins.
The graph below shows our interest rate risk exposure on
October 31, 2002 on the closed (non-optioned) instruments
within the financial position. If this portfolio had experienced
an immediate and sustained 100 basis point decrease in rates
on October 31, 2002, the economic value of shareholders’
equity would have decreased by $6 million after-tax (2001 –
$9 million). This same shock would reduce net income after tax
by $2 million over the next 12 months (2001 –$6 million). Our
EVaR in the closed book ranged from nil to $17 million during
the year ended October 31, 2002.
Product options, which expose TD to a non-linear or
asymmetrical payoff profile, represent a significant financial risk,
whether they are free-standing, such as mortgage rate
commitments or embedded in loans and deposits. Product
option exposures are managed by purchasing options or through
a dynamic hedging process designed to replicate the payoff of a
purchased option. Dynamic hedging involves rebalancing the
hedging instruments we hold for small changes in interest rates.
The following graph shows our interest rate risk exposure on
October 31, 2002 on all instruments within the financial
position: the closed (non-optioned) instruments plus product
options. The following graph assumes that the dynamic hedging
portfolios held on October 31 are not rebalanced for the interest
rate shock. An immediate and sustained 100 basis point
decrease in rates would have decreased the economic value
of shareholders’equity by $46 million after-tax (2001 –
$40 million) or .4% of common equity. Our EVaR for the total
portfolio ranged from $28 million to $73 million during the year
ended October 31, 2002. TD’s policy sets overall limits on asset
liability mismatched positions that EVaR does not exceed 3% of
TD’s common equity ($347 million) and EaR does not exceed
3% of TD’s annualized net interest income ($159 million).
1The interest rate risk exposure of non-maturity deposits and loans is
measured based on assumed maturity profiles.
Closed (non-optioned) instruments portfolio
economic value at risk by interest rate shock1
(millions of dollars as of October 31, 2002)
$20
10
0
-10
-20
-150 -75 0 75 150
Changes in present value after-tax
Parallel interest rate shock (basis points)