TD Bank 2010 Annual Report Download - page 105

TD BANK GROUP ANNUAL REPORT 2010 FINANCIAL RESULTS 103
The cumulative adjustment to the carrying amount of the hedged
item (the basis adjustment) is amortized to the Consolidated Statement
of Income based on a recalculated effective interest rate over the
remaining expected life of the hedged item, with amortization
beginning no later than when the hedged item ceases to be adjusted
for changes in its fair value attributable to the hedged risk. Where
the hedged item has been derecognized, the basis adjustment is
immediately released to the Consolidated Statement of Income.
Cash Flow Hedges
The Bank is exposed to variability in future cash flows that are
denominated in foreign currencies, as well as variability in future cash
flows of non-trading assets and liabilities that bear interest at variable
rates, or are expected to be refunded or reinvested in the future. The
amounts and timing of future cash flows are projected for each
hedged exposure on the basis of their contractual terms and other
relevant factors, including estimates of prepayments and defaults. The
aggregate cash flows across all hedged exposures over time form the
basis for identifying the effective portion of gains and losses on the
derivatives designated as cash flow hedges of forecasted transactions.
The effective portion of changes in the fair value of derivatives
that are designated and qualify as cash flow hedges is recognized in
other comprehensive income. Any change in fair value relating to the
ineffective portion is recognized immediately in the Consolidated
Statement of Income in other income.
Amounts accumulated in other comprehensive income are reclassified
to the Consolidated Statement of Income in the period in which the
hedged item affects income.
When a hedging instrument expires or is sold, or when a hedge
no longer meets the criteria for hedge accounting, any cumulative gain
or loss existing in other comprehensive income at that time remains
in other comprehensive income until the forecasted transaction is
eventually recognized in the Consolidated Statement of Income. When
a forecasted transaction is no longer expected to occur, the cumulative
gain or loss that was reported in other comprehensive income is
immediately transferred to the Consolidated Statement of Income.
Net Investment Hedges
Hedges of net investments in foreign operations are accounted for
similar to cash flow hedges. Any change in fair value on the hedging
instrument relating to the effective portion of the hedge is recognized
in other comprehensive income. The change in fair value relating to the
ineffective portion is recognized immediately in the Consolidated State-
ment of Income. Gains and losses accumulated in other comprehensive
income are included in the Consolidated Statement of Income upon the
repatriation or disposal of the investment in the foreign operation.
DERIVATIVE PRODUCT TYPES AND RISK EXPOSURES
The majority of the Bank’s derivative contracts are over-the-counter
(OTC) transactions that are privately negotiated between the Bank and
the counterparty to the contract. The remainder are exchange-traded
contracts transacted through organized and regulated exchanges and
consist primarily of options and futures.
Interest Rate Derivatives
The Bank uses interest rate derivatives, such as interest rate futures
and forwards, swaps, and options in managing interest rate risks.
Interest rate risk is the impact that changes in interest rates could
have on the Bank’s margins, earnings, and economic value. Changes
in interest rate can impact the market value of fixed rate assets and
liabilities. Further, certain assets and liabilities repayment rates vary
depending on interest rates.
Forward rate agreements are OTC contracts that effectively fix a
future interest rate for a period of time. A typical forward rate agree-
ment provides that at a pre-determined future date, a cash settlement
will be made between the counterparties based upon the difference
between a contracted rate and a market rate to be determined in the
future, calculated on a specified notional principal amount. No exchange
of principal amount takes place.
Derivative financial instruments are financial contracts that derive their
value from underlying changes in interest rates, foreign exchange
rates, credit spreads, commodity prices, equities, or other financial
measures. Such instruments include interest rate, foreign exchange,
equity, commodity and credit derivative contracts. The Bank uses these
instruments for trading purposes and non-trading purposes to manage
the risks associated with its funding and investment strategies.
DERIVATIVES HELD FOR TRADING PURPOSES
The Bank enters into trading derivative contracts to meet the needs
of its customers, to enter into trading positions, and in certain cases,
to manage risks related to its trading portfolio. Trading derivatives
are recorded at fair value with the resulting realized and unrealized
gains or losses recognized immediately in trading income.
DERIVATIVES HELD FOR NON-TRADING
When derivatives are held for non-trading purposes and when the
transactions meet the requirements of Section 3865, Hedges, they
are classified by the Bank as non-trading derivatives and receive
hedge accounting treatment, as appropriate. Certain derivative
instruments that are held for economic hedging purposes, and do
not meet the requirements of Section 3865, are also classified as
non-trading derivatives but the change in fair value of these
derivatives is recognized in other income.
HEDGING RELATIONSHIPS
Hedge Accounting
At the inception of a hedging relationship, the Bank documents the
relationship between the hedging instrument and the hedged item, its
risk management objective and its strategy for undertaking the hedge.
The Bank also requires a documented assessment, both at hedge
inception and on an ongoing basis, of whether or not the derivatives
that are used in hedging transactions are highly effective in offsetting
the changes attributable to the hedged risks in the fair values or cash
flows of the hedged items. In order to be deemed effective, the hedg-
ing instrument and the hedged item must be highly and inversely
correlated such that the changes in the fair value of the hedging
instrument will substantially offset the effects of the hedged exposure
to the Bank throughout the term of the hedging relationship. If a
hedging relationship becomes ineffective, it no longer qualifies for
hedge accounting and any subsequent change in the fair value of the
hedging instrument is recognized in earnings, without any mitigating
impact in earnings, where appropriate.
The change in fair value relating to the derivative component
excluded from the assessment of hedge effectiveness is recognized
immediately in the Consolidated Statement of Income.
When derivatives are designated as hedges, the Bank classifies them
either as: (i) hedges of the change in fair value of recognized assets or
liabilities or firm commitments (fair value hedges); (ii) hedges of the
variability in highly probable future cash flows attributable to a recog-
nized asset or liability, or a forecasted transaction (cash flow hedges);
or (iii) hedges of net investments in a foreign operation (net invest-
ment hedges).
Fair Value Hedges
The Bank’s fair value hedges principally consist of interest rate swaps that
are used to protect against changes in the fair value of fixed-rate long-
term financial instruments due to movements in market interest rates.
Changes in the fair value of derivatives that are designated and
qualify as fair value hedging instruments are recorded in the Consolidated
Statement of Income, along with changes in the fair value of the
assets, liabilities or group thereof that are attributable to the hedged
risk. Any change in fair value relating to the ineffective portion of the
hedging relationship is recognized immediately in the Consolidated
Statement of Income in other income.
DERIVATIVES
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