Bank of Montreal 1998 Annual Report Download - page 55

47
BANK OF MONTREAL GROUP OF COMPANIES
reflection of our risk, since money market portfolios represent a significant component of
our sensitivity, and as these are very short-term in nature we would normally be able to close
these positions before a full 100 basis point increase occurred.
INTEREST RATE RISK SENSITIVITY –RISING INTEREST RATES
Structural and Money Market Portfolios
As at October 31, 1998 (after-tax Canadian equivalent $ millions) 100 Basis Point Increase Rising Interest Rate Risk (b)
Earnings at risk†over the next 12 months (a) (38.8) (32.2)
Economic value-at-risk†(a) (333.0) (451.3)
(a) Risk measures include the impact of embedded options but exclude actions that we could take to reduce risk or the actions
that customers might take in response to changing rates. Other assumptions are consistent with those disclosed for the gap
position in Table 7 on page 58 of the Annual Report.
(b)
Risk measures are based upon statistical analysis of historical data on an individual portfolio basis using a 97.5%
confidence level.
Market Risk Sensitivity
Our Market Risk Sensitivity model uses the same core principles as the Rising Interest Rate Risk
model, but in addition to rising interest rate risk, it incorporates the impact of all adverse
mar ket rate/price changes within the different time periods required to close each of our port-
folios. The model also views each portfolio separately and hence can be more conservative
than if the effects of correlation (namely, interdependence) between portfolios were included.
MARKET RISK SENSITIVITY –ADVERSE CHANGES IN MARKET RATES/PRICES (a)
1998 1997
As at October 31 (after-tax Canadian equivalent $ millions) Cdn$ US$ Cdn$ US$
Earnings at risk over the next 12 months (b) (43.1) (33.2) (59.6) (34.8)
Economic value-at-risk (b) (390.3) (104.7) (250.9) (83.2)
(a) Earnings at risk and economic value at risk include Cdn$(22.7) and US$(16.7) in 1998, and Cdn$(20.5) and US$(17.9) in 1997,
related to trading portfolios.
(b) Assumptions for the model are consistent with (a) and (b) under Interest Rate Risk Sensitivity, with the additional inclusion
of minimum rates on deposits.
In the fourth quarter of 1998 we incurred trading losses of $90 million after-tax. The trading
losses were a result of abnormal market conditions which drove a widening of credit spreads
and reduced liquidity in the corporate debt markets. We continue to manage our remaining
positions very closely, and have reduced our exposure where appropriate. These trading losses
did not exceed our overall aggregate risk parameters. The increase in economic value-at-risk
from 1997 to 1998 reflects the impact of recent market conditions on the historical data
included in our model, as well as continued asset growth.
LIQUIDITY RISK
Approach:
Our approach to liquidity management is to measure and forecast liquidity requirements
based on expected economic, political and Bank-specific events. This enables us to deter-
mine if we have sufficient funds available to meet all short-term liquidity demands, even
in times of crisis. Funds encompass both liquid assets on hand and the capability to raise
additional funds to meet liquidity requirements. Liquidity risk is measured by estimating our
potential liquidity and funding requirements under stressed environments. We continuously
monitor liquidity risk and actively manage our balance sheet to minimize this risk. Our
liquidity management approach has two main goals: diversification to prevent funding
problems and maintenance of an appropriate level of liquid assets. Our methodology for
meeting these goals is outlined below.
Our goal is to maintain sufficient funds and funding capacity to meet our net cash outflow
commitments, both on- and off-balance sheet, so that in the event of a liquidity crisis such
commitments will be covered without having to raise funds at unreasonable prices or sell
assets on a forced basis. Management establishes minimum liquid asset requirements, togethe r
with limits and guidelines for liability diversification and standby funding commitments.
S
ensitivity analyses are run to determine the impact of deposit withdrawals and commitment
DERIVATIVES†
Derivative contracts can either
be exchange traded (such
as futures and some types of
options) or over-the-counter†
transactions including interest
rate and cross-currency swaps,
forward rate agreements (FRAs),
caps and floors, as well as other
types of options†. We use finan-
cial derivatives to manage
market risk for both trading and
hedging purposes. We also offer
derivative products to customers
for their own risk management
and investment purposes. The
two primary risks arising from
the use of derivative products
are credit risk/replacement risk,
and market risk. These risks
are described, managed and
measured as stated earlier.
For regulatory purposes,
we also calculate the credit risk
equivalent for our interest rate
and foreign exchange derivative
contracts on a BIS basis. This
includes the cost of replacing,
at current market rates, all
contracts that have a positive
fair value, plus the potential
for future changes based on a
formula using parameters pre-
scribed by OSFI. Our internal
parameters are more conserva-
tive than those prescribed by
OSFI. The credit risk equivalent
as at October 31, 1998 was
$13.1 billion as compared to
$8.0 billion in 1997.
Additional disclosure with
regard to derivatives is found
in note 21 to the consolidated
financial statements.
STRATEGY:
We manage our balance sheet
to ensure that we have or can
obtain sufficient liquid resources
in both a timely manner and
at a reasonable price to meet
customer requirements and our
own operating needs.
MEASURE:
The liquidity ratio is our primary
measure for liquidity coverage
and represents the ratio of cash,
securities and deposits with
other banks (liquid assets) to
total assets.
†Defined in the Glossary on page 92