TD Bank 2007 Annual Report Download - page 115

TD BANK FINANCIAL GROUP ANNUAL REPORT 2007 Financial Results 111
Interest rate swaps are over-the-counter contracts in which two
counterparties agree to exchange cash flows over a period of time
based on rates applied to a specified notional principal amount.
A typical interest rate swap would require one counterparty to
pay a fixed market interest rate in exchange for a variable market
interest rate determined from time to time, with both calculated
on a specified notional principal amount. No exchange of princi-
pal amount takes place.
Interest rate options are contracts in which one party (the
purchaser of an option) acquires from another party (the writer
of an option), in exchange for a premium, the right, but not
the obligation, either to buy or sell, on a specified future date
or within a specified time, a specified financial instrument at a
contracted price. The underlying financial instrument will have a
market price which varies in response to changes in interest rates.
In managing the Bank’s interest rate exposure, the Bank acts
as both a writer and purchaser of these options. Options are
transacted both over-the-counter and through exchanges.
Interest rate futures are standardized contracts transacted on
an exchange. They are based upon an agreement to buy or sell a
specified quantity of a financial instrument on a specified future
date, at a contracted price. These contracts differ from forward
rate agreements in that they are in standard amounts with
standard settlement dates and are transacted on an exchange.
Foreign Exchange Derivatives
Foreign exchange forwards are over-the-counter contracts in
which one counterparty contracts with another to exchange
a specified amount of one currency for a specified amount of
a second currency, at a future date or range of dates.
Swap contracts comprise foreign exchange swaps and
cross-currency interest rate swaps. Foreign exchange swaps
are transactions in which a foreign currency is simultaneously
purchased in the spot market and sold in the forward market,
or vice-versa. Cross-currency interest rate swaps are transactions
in which counterparties exchange principal and interest flows
in different currencies over a period of time. These contracts
are used to manage both currency and interest rate exposures.
Foreign exchange futures contracts are similar to foreign
exchange forward contracts but differ in that they are in
standard currency amounts with standard settlement dates
and are transacted on an exchange.
Credit Derivatives
Credit derivatives are over-the-counter contracts designed to
transfer the credit risk in an underlying financial instrument
(usually termed as a reference asset) from one counterparty to
another. The most common credit derivatives are credit default
swaps (referred to as option contracts) and total return swaps
(referred to as swap contracts). In option contracts, an option
purchaser acquires credit protection on a reference asset or group
of assets from an option writer in exchange for a premium. The
option purchaser may pay the agreed premium at inception or
over a period of time. The credit protection compensates the
option purchaser for any deterioration in value of the reference
asset upon the occurrence of certain credit events such as bank-
ruptcy or failure to pay. Settlement may be cash based or physical,
requiring the delivery of the reference asset to the option writer.
In swap contracts, 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. These cash settlements
are made regardless of whether there is a credit event.
Other Derivatives
The Bank also transacts equity and commodity derivatives in both
the exchange and over-the-counter markets.
Equity swaps are over-the-counter contracts in which one
counterparty agrees to pay, or receive from the other, cash
amounts based on changes in the value of a stock index, a basket
of stocks or a single stock. These contracts sometimes include
a payment in respect of dividends.
Equity options give the purchaser of the option, for a premium,
the right, but not the obligation, to buy from or sell to the writer
of an option, an underlying stock index, basket of stocks or
single stock at a contracted price. Options are transacted both
over-the-counter and through exchanges.
Equity index futures are standardized contracts transacted on
an exchange. They are based on an agreement to pay or receive
a cash amount based on the difference between the contracted
price level of an underlying stock index and its corresponding
market price level at a specified future date. There is no actual
delivery of stocks that comprise the underlying index. These
contracts are in standard amounts with standard settlement
dates.
Commodity contracts include commodity forward, futures,
swaps and options, such as precious metals and energy-related
products in both over-the-counter and exchange markets.
The Bank issues certain loan commitments to customers at
a fixed price. These funding commitments are accounted for as
derivatives if there is past practice of selling the loans shortly
after funding. Loan commitments are carried at fair value with
the resulting realized and unrealized gains or losses recognized
immediately in other income.
NOTIONAL AMOUNTS
The notional amounts are not recorded as assets or liabilities
as they represent the face amount of the contract to which a
rate or price is applied to determine the amount of cash flows
to be exchanged. Notional principal amounts do not represent
the potential gain or loss associated with market risk and are
not indicative of the credit risk associated with derivative
financial instruments.
EMBEDDED DERIVATIVES
Derivatives may be embedded in other financial instruments (the
“host instrument”). Prior to the adoption of the new accounting
standards on November 1, 2006, such embedded derivatives were
not accounted for separately from the host instrument, except in
the case of derivatives embedded in equity-linked deposit con-
tracts within the scope of Accounting Guideline 17, Equity-linked
deposit contracts, which has been replaced by CICA Handbook
Section 3855, Financial Instruments – Recognition and
Measurement. Under the new standards, embedded derivatives
are treated as separate derivatives when their economic charac-
teristics and risks are not clearly and closely related to those of
the host instrument, a separate instrument with the same terms
as the embedded derivative would meet the definition of a deriva-
tive, and the combined contract is not held for trading or desig-
nated at fair value. These embedded derivatives are measured at
fair value with subsequent changes recognized in trading income.
Certain of the Bank’s deposit obligations that vary according
to the performance of certain equity levels or indices, may be
subject to a guaranteed minimum redemption amount and have
an embedded derivative. The Bank accounts for the embedded
derivative of such variable obligations at fair value with changes
in fair value reflected in income as they arise. The Bank does not
expect significant future earnings volatility as the embedded
derivatives are effectively hedged.