Bank of Montreal 2007 Annual Report Download - page 112

Capital Trusts
BMO Subordinated Notes Trust (the “SN Trust”) was created in 2007
to issue $800 million of BMO Trust Subordinated Notes –Series A.
SN Trust used the proceeds of the offering to purchase a senior deposit
note from the Bank. We are not required to consolidate the SN Trust.
Refer to Note 18 for more details on the subordinated notes issued
by the SN Trust.
We also provide liquidity support amounting to $30 million to
the SN Trust. As at October 31, 2007, $5 million had been drawn.
BMO Capital Trust (the “Trust”) was created to issue BMO Capital
Trust Securities (“BOaTS”). As at October 31, 2007, the Trust had
assets of $3,140 million ($3,180 million in 2006). The Trust is a VIE
which we are required to consolidate. Refer to Note 19 for more details
on the BOaTS.
Other VIEs
We are involved with other entities that may potentially be VIEs.
This involvement can include, for example, acting as a derivatives
counterparty, liquidity provider, investor, fund manager or trustee.
These activities do not cause us to be exposed to a majority of
the expected losses of these VIEs or allow us to benefit from a majority
of their expected residual returns. As a result, we are not required
to consolidate these VIEs. Transactions with these VIEs are conducted at
market rates, and individual credit or investment decisions are based
upon the analysis of the specific VIE, taking into consideration the quality
of the underlying assets. We record and report these transactions in
the same manner as other transactions. For example, derivatives con-
tracts are recorded in accordance with our derivatives accounting policy
as outlined in Note 9. Liquidity facilities are described in Note 6.
108 BMO Financial Group 190th Annual Report 2007
Notes to Consolidated Financial Statements
Notes
Note 9: Derivative Instruments
Change in Accounting Policy
On November 1, 2006, we adopted the CICA’s new accounting require-
ments for hedging derivatives. The new rules require us to record
all of our hedging derivatives at fair value. Prior to November 1, 2006,
we accounted for derivatives that qualified as accounting hedges on
an accrual basis.
The types of hedging relationships that qualify for hedge accounting
have not changed under the new rules. We will continue to designate
our hedges as either cash flow hedges or fair value hedges.
Changes in the fair value of hedging derivatives are either offset
in our Consolidated Statement of Income against the changes in the
fair value of the risk being hedged, or recorded in other comprehensive
income, unrealized gain (loss) on cash flow hedges. If the change in
fair value of the derivative is not completely offset by the change in fair
value of the item it is hedging, the difference is recorded immediately
in our Consolidated Statement of Income.
Derivative instruments are financial contracts that derive their value from
underlying changes in interest rates, foreign exchange rates or other
financial or commodity prices or indices.
Derivative instruments are either regulated exchange-traded con-
tracts or negotiated over-the-counter contracts. We use these instruments
for trading purposes, as well as to manage our exposures, mainly
to currency and interest rate fluctuations, as part of our asset/liability
management program.
Types of Derivatives
Swaps
Swaps are contractual agreements between two parties to exchange
a series of cash flows. The various swap agreements that we enter into
are as follows:
Interest rate swaps
–
counterparties generally exchange fixed
and floating rate interest payments based on a notional value in a
single currency.
Cross-currency swaps –fixed rate interest payments and principal
amounts are exchanged in different currencies.
Cross-currency interest rate swaps –fixed and floating rate interest
payments and principal amounts are exchanged in different currencies.
Commodity swaps –counterparties generally exchange fixed and
floating rate payments based on a notional value of a single commodity.
Equity swaps –counterparties exchange the return on an equity
security or a group of equity securities for the return based on a fixed
or floating interest rate or the return on another equity security or
a group of equity securities.
Credit default swaps –one counterparty pays the other a fee in
exchange for that other counterparty agreeing to make a payment if a
credit event occurs, such as bankruptcy or failure to pay.
Total return swaps
–
one counterparty agrees to pay or receive
from the other cash amounts based on changes in the value of a
reference asset or group of assets, including any returns such as interest
earned on these assets, in exchange for amounts that are based on
prevailing market funding rates.
The main risks associated with these instruments are related to the
exposure to movements in interest rates, foreign exchange rates, credit
quality, securities values or commodities prices, as applicable, and the
possible inability of counterparties to meet the terms of the contracts.
Forwards and Futures
Forwards and futures are contractual agreements to either buy or sell
a specified amount of a currency, commodity, interest-rate-sensitive
financial instrument or security 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.
The main risks associated with these instruments arise from the
possible inability of over-the-counter counterparties to meet the terms
of the contracts and from movements in commodities prices, securities
values, interest rates and foreign exchange rates, as applicable.
Options
Options are contractual agreements that convey to the buyer the
right but not the obligation to either buy or sell a specified amount of
a currency, commodity, interest-rate-sensitive financial instrument or
security 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 purchaser
for accepting market risk.
For options purchased by us, we pay a premium for the right to
exercise the option. Since we have no obligation to exercise the option,
our primary exposure to risk is the potential credit risk if the writer of
an over-the-counter contract fails to fulfill the conditions of the contract.
Caps, collars and floors are specialized types of written and
purchased options. They are contractual agreements where the writer
agrees to pay the purchaser, based on a specified notional amount, the
difference between the market rate and the prescribed rate of the cap,
collar or floor. The writer receives a premium for selling this instrument.
Uses of Derivatives
Trading Derivatives
Trading derivatives include derivatives entered into with customers
to accommodate their risk management needs, derivatives transacted
to generate trading income from our own proprietary trading positions
and certain derivatives that do not qualify as hedges for accounting
purposes (“economic hedges”).
We structure and market derivative products to customers to enable
them to transfer, modify or reduce current or expected risks.