Bank of Montreal 2000 Annual Report Download - page 48

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Results
The composition of the trading and non-trading market risk positions as at October 31, 2000 were
within our Corporate Standard for Market Value Exposure. Results of back-testing and stress
testing of the output of our models have also been within limits.
In the third quarter of 2000, exposure to natural gas price volatility resulted in a pre-tax loss of
$52 million ($30 million after-tax). Although the positions were within the tolerance limits set
for those activities, a detailed examination of the background resulted in modifications to exist-
ing processes and other management actions to constrain exposure to future losses in this area.
Overall, the BIS “minimum capital requirement for market risk” is $372 million as at Octo-
ber 31, 2000, down from $538 million as at the end of 1999. This reduction was mainly attributable
to commodities and reflects both the adoption of more capital-efficient VaR methodology and
reduced commodity exposures.
Trading and Underwriting Market Risk Management
Trading risk management is based on a number of risk measures and associated limits. The key elements of this
structure are:
■magnitude of risk;
■sources or concentrations of risk;
■scenario analysis and stress testing of risk positions; and
■sensitivity and stability measures.
Magnitude of risk
is measured in Market Value Exposure terms. This measure calculates the maximum likely loss
from a given portfolio of trading assets. The risk tool generally employed for this measure is VaR. VaR is calculated
at a 99% confidence level for a holding period of one day (for capital purposes, VaR is also calculated with a
holding period of 10 days). VaR is the measurement tool and the Corporate Standard for Market Value Exposure
is the associated limit structure.
Sources and concentrations of risk
are measured based on specific risk categories. This measure allows the
trading operation to ensure that there are no undue concentrations of risks (examples are credit spread risk,
interest rate Vega risk and the level of risk in specific currencies).
Scenario analysis and stress testing
have become recognized in the industry over the past few years as key
risk management tools. The trading units are subject to stress test limits and, increasingly, are able to evaluate
risk scenarios to determine outcomes from possible or probable market movements. The Bank is committed to
continuing development in this area.
Sensitivity and stability analysis
is focused on understanding and measuring the model risk associated with
the use of highly sophisticated pricing and risk tools. The process seeks to determine those input or calibration
parameters to which the model is most sensitive and which are the most variable or unstable. This provides
an understanding of the range of possible values from the models employed.
Structural and Money Market Interest Rate Risk Management
Interest rate risk is a principal non-trading market risk. We use two primary risk models to determine the
sensitivity of our non-trading portfolios to adverse interest rate changes. Our first model is the 100 basis point
increase model, which calculates the impact on earnings over a 12-month horizon and on the value of our assets
and liabilities of a one-time 100 basis point increase across all portfolios. This model is used by most financial
institutions and hence facilitates comparability with our peers.
Our second model is the “interest rate risk model,” which is used internally as a more sophisticated measure
of risk. This model calculates the impact on earnings over the next 12 months and on the value of our
assets
and liabilities of a one-time change in rates. At a 99% confidence level, it reflects the maximum expected
interest
rate change in each portfolio during the estimated period required to close our positions in that portfolio.
Management considers this a more accurate reflection of our interest rate risk. Our money market instruments
are short-term in nature and we would normally be able to close them before a full 100 basis point interest rate
increase occurred.
Enterprise-Wide Risk Management
24 ■Bank of Montreal Group of Companies Annual Report 2000