Bank of Montreal 2000 Annual Report Download - page 85

Bank of Montreal Group of Companies Annual Report 2000 ■61
Note 21 Derivative Financial Instruments
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.
Customer trading derivative transactions are comprised of sales and
other activities. Sales activities include the structuring and market-
ing of derivative products to customers to enable them to transfer,
modify or reduce current or expected risks. Other activities include
market-making, positioning and arbitrage activities. Market-making
involves quoting bid and offer prices to other market participants
with the intention of generating revenues based on spread and
volume. Positioning involves managing market risk positions with
the expectation of profiting from favourable movements in prices,
rates or indices. Arbitrage activities involve identifying and profit-
ing from price differentials between markets and products.
Customer trading derivatives 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, model and
liquidity risks as well as administrative costs is deferred and amortized to
income over the life of the contracts. Unrealized gains on trading deriva-
tives are recorded in other assets and unrealized losses are recorded in
other liabilities.
Asset/liability management derivatives are those instruments that
are designated and documented as effective as hedges. We use these
instruments to manage exposures in accordance with our risk manage-
ment strategy. 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 inception 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 unreal-
ized 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. Premiums on purchased options 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 appropriate.
Realized gains and losses from the settlement or the early termination of
contracts are deferred and amortized over the remaining original life of
the hedging instrument. Subsequent changes in the fair value of instru-
ments identified as hedges, but which are no longer effective as hedges,
are redesignated as customer trading and 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
Swaps are contractual agreements between two parties to exchange
a series of cash flows.
For interest rate swaps, counterparties generally exchange fixed
and floating rate interest payments based on a notional value in a
single currency. The main risks associated with these instruments
are the exposure to movements in interest rates and the ability of
the counterparties to meet the terms of the contract. Interest rate
swaps are used to adjust exposure to interest rate risk by modifying
the repricing or maturity characteristics of assets and liabilities.
For cross-currency swaps, fixed interest payments and notional
amounts are exchanged in different currencies.
For cross-currency interest rate swaps, principal amounts and fixed
and floating interest payments are exchanged in different currencies.
For commodity swaps, counterparties generally exchange fixed and
floatingratepaymentsbasedonanotionalvalueinasinglecommodity.
Forwards and Futures
Forwards and futures are contractual agreements to either buy or
sell a specified currency, commodity or financial instrument at a spe-
cific 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. Risks arise from the possible inability of
over-the-counter counterparties to meet the terms of their contracts
and from movements in securities values, interest rates and foreign
exchange rates.
We periodically use forward exchange contracts to hedge con-
tractual U.S. dollar revenues to minimize fluctuations in U.S. dollar
earnings. These forward exchange contracts mature monthly as
related revenues are recognized. There was no unrecognized gain or
loss associated with these forward contracts as at October 31, 2000
and there was a $5.9 unrealized gain as at October 31, 1999.
Options
Options 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 14 of our Management Analysis of Operations.
Losses incurred on defaults of counterparties charged to the allow-
ance for credit losses in the years ended October 31, 2000, 1999 and
1998 were not significant.
The effect of asset/liability management derivatives on net interest
income and the net amount of deferred realized losses was:
2000 1999 1998
Asset/Liability Management Derivatives
Increase (decrease) in net interest income $94 $ 27 $ 37
Deferred realized (losses) $ (15) $ (1) $ (15)
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.