Bank of Montreal 1998 Annual Report Download - page 93

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BANK OF MONTREAL GROUP OF COMPANIES
We enter into interest rate, foreign exchange, equity and commodity
contracts, to enable customers to manage risk, and for asset/liability
management purposes where we manage our on- and off-balance
sheet positions.
Trading derivatives are those derivatives which we undertake in
order to assist customers in managing their exposures and to generate
income from managing the resulting trading positions. Trading deriva-
tives are marked to market. Realized and unrealized gains and losses
are recorded in other income. A portion of the income derived from
marking derivatives to market in respect of credit risk premiums and
administrative costs is deferred and amortized to income over the life
of the contracts. Unrealized gains on trading derivatives are recorded
in other assets and unrealized losses are recorded in other liabilities.
Asset/liability management derivatives are those which are desig-
nated and effective as hedges which we use to manage exposures
arising from our positions. For a hedge to be effective, changes in the
market value of the derivative must be highly correlated with changes
in the market value of the underlying hedged item at incep tion and
over the life of the hedge. Swaps, forwards and options, which are
used for such purposes, are accounted for on the accrual basis,
under which income and expense from the derivative instrument is
accrued and there is no recognition of unrealized gains and losses on
the derivative in the balance sheet. For swaps and forwards, interest
income and expense from the hedging instrument is accrued and
recorded as an adjustment to the income or expense related to the
hedged position. Option premiums are amortized over the life of the
contract to the income or expense line associated with the hedged
position. Accrued interest receivable and payable and deferred gains
and losses are recorded in other assets or other liabilities as appropri-
ate. Realized gains and losses from the settlement or the early termi-
nation of contracts are deferred and amortized over the remaining life
of the hedging instrument. Subsequent changes in the fair value of
instruments identified as hedges, but which are no longer effective as
hedges, are reported in other income.
Derivatives transactions, which are conducted in the over-the-counter
market directly between two counterparties or on regulated exchange
markets, include:
Swaps, which are contractual agreements between two parties to
exchange a series of cash flows. For interest rate swaps, counterpar-
ties generally exchange fixed and floating rate interest payments
based on a notional value in a single currency. For cross-currency
swaps, fixed interest payments and notional amounts are exchanged
in different currencies. For cross-currency interest rate swaps, prin-
cipal amounts and fixed and floating rate interest payments are
exchanged in different currencies. For commodity swaps, counter-
parties generally exchange fixed and floating rate payments based
on a notional value in a single commodity.
Forwards and futures, which are contractual agreements to either
buy or sell a specified currency, commodity or financial instrument
at a specific
price and date in the future. Forwards are customized
contracts
transacted in the over-the-counter market. Futures are
transacted in standardized amounts on regulated exchanges and are
subject to daily cash margining.
Options, which are contractual agreements that convey the right
but not the obligation to either buy or sell a specific amount of a
currency, commodity or
financial instrument at a fixed price either
at a fixed future date or at any time within a fixed future period.
For options written by us, we receive a premium from the pur-
chaser for accepting market risk. For options purchased by us, a
premium is paid for the right to exercise the option, but we sustain
credit risk due to the uncertainty as to the writer’s ability to fulfill
the conditions of the contract. Also included in options are caps,
collars and floors, which are contractual agreements where the
writer agrees to pay the purchaser, based on a specified notional
amount, the agreed upon difference between the market rate and
the prescribed rate of the cap, collar or floor. The writer receives a
premium for selling this instrument.
We conduct our trading activities through business units dealing
in both on- and off-balance sheet positions, including derivatives,
which are marked to market. The revenue generated by these units
is disclosed on page 28 of the Management Analysis of Operations.
Losses incurred on defaults of counterparties charged to the allow-
ance
for credit losses in the years ended October 31, 1998, 1997 and
1996 were not significant.
The effect of asset/liability management derivatives on net
interest income and the amount of deferred losses on such con-
tracts
was:
1998 19 97 199 6
Asset/Liability Management Derivatives
Increase in net interest income $ 37 $ 89 $ 33
Deferred realized (losses) $ (15) $ (14) $ (3)
The following table summarizes our derivative portfolio and related
credit exposure:
Notional amount: represents the amount to which a rate or price is
applied in order to calculate the exchange of cash flows.
Replacement cost: represents the cost of replacing, at current market
rates, all contracts which have a positive fair value, in effect the un-
realized gains. Derivative instruments transacted through exchanges
are subject to daily margin requirements. Such instruments are
excluded from the calculation of risk-weighted assets as they are
deemed to have no additional credit risk. The amounts take into
consideration offsetting, when we have a legally enforceable right to
offset and intend either to settle on a net basis or to realize the asset
and settle the liability simultaneously.
Credit risk equivalent: represents the total replacement cost and
potential future credit exposure, taking into consideration offsetting
as permitted by the Superintendent of Financial Institutions Canada.
Risk-weighted balance: represents the credit risk equivalent,
weighted according to the creditworthiness of the counterparty, as
prescribed by the Superintendent of Financial Institutions Canada.
NOTE 21 DERIVATIVE FINANCIAL INSTRUMENTS
participation in clearing and payment systems and as security for
contract settlements with derivatives exchanges or other derivative
counterparties.
(f) Cash Restrictions
Some of our subsidiaries are required to maintain reserves or mini-
mum balances with central banks in their respective countries of
operation. Cash resources included $327
of these balances as at
October 31, 1998
and $398 as at October 31, 1997.