Bank of Montreal 2007 Annual Report Download - page 113

Proprietary 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 activities involve
managing market risk positions with the expectation of profiting
from favourable movements in prices, rates or indices. Arbitrage activities
involve identifying and profiting from price differentials between
markets and products.
We may also take proprietary trading positions in various capital
market instruments and derivatives that, taken together, are designed
to profit from anticipated changes in market factors.
Trading derivatives are marked to fair value. Realized and unrealized
gains and losses are recorded in trading revenues in our Consolidated
Statement of Income. Unrealized gains on trading derivatives are
recorded as derivative instrument assets and unrealized losses are
recorded as derivative instrument liabilities in our Consolidated
Balance Sheet.
Hedging Derivatives
In accordance with our risk management strategy, we enter into
various derivative contracts to hedge our interest rate and foreign
currency exposures.
Risks Hedged
Interest Rate Risk
We manage interest rate risk through interest rate swaps and options,
which are linked to and adjust the interest rate sensitivity of a specific
asset, liability, forecasted transaction, firm commitment, or a specific
pool of transactions with similar risk characteristics.
In order for an interest rate derivative to qualify as a hedge,
the hedging relationship must be designated and formally documented
at its inception, detailing the particular risk management objective
and strategy for the hedge and the specific asset, liability or cash flow
being hedged, as well as how effectiveness is being assessed. Changes
in the fair value of the derivative must be highly effective in offsetting
either changes in the fair value of on-balance sheet items or changes
in the amount of future cash flows.
Hedge effectiveness is evaluated at the inception of the hedging
relationship and on an ongoing basis, both retrospectively and prospec-
tively, primarily using quantitative statistical measures of correlation. Any
ineffectiveness in the hedging relationship is recognized in non-interest
revenue, other in the Consolidated Statement of Income, as it arises.
Cash Flow Hedges
Cash flow hedges modify exposure to variability in cash flows for
variable rate interest bearing instruments or the forecasted issuance
of fixed rate liabilities. Our cash flow hedges, which have a maximum
term of 13 years, are primarily hedges of floating rate deposits as
well as commercial and personal loans.
Under the new rules, we will continue to record interest receivable
or payable on the derivative as an adjustment to interest, dividend
and fee income in the Consolidated Statement of Income over the life
of the hedge.
To the extent that changes in the fair value of the derivative offset
changes in the fair value of the hedged item, they are recorded in
other comprehensive income. Any portion of the change in fair value
of the derivative that does not offset changes in the fair value of the
hedged item (the ineffectiveness of the hedge) is recorded directly
in non-interest revenue, other in the Consolidated Statement of Income.
Losses on the ineffective portion of our cash flow hedges totalled less
than $1 million for the year ended October 31, 2007.
For cash flow hedges that are discontinued before the end of the
original hedge term, the unrealized gain or loss in other comprehensive
income is amortized to interest, dividend and fee income in the Con-
solidated Statement of Income as the hedged item impacts earnings.
If the hedged item is sold or settled, the entire unrealized gain or
loss
is recognized in interest, dividend and fee income in the Consolidated
Statement of Income. The amount of other comprehensive loss that is
expected to be reclassified to the Consolidated Statement of Income
over the next 12 months is $64 million ($42 million after tax). This will
be offset by increased net interest income on assets and liabilities
that were hedged.
On November 1, 2006, we remeasured our cash flow hedging
derivatives at fair value. The portion of the fair value that offset the
fair value of the hedged item was an $8 million gain ($5 million after
tax) and was recorded in opening accumulated other comprehensive
income. The ineffective portion of cash flow hedges recorded in opening
retained earnings totalled less than $1 million. We also reclassified
$86 million ($56 million after tax) of deferred losses related to cash
flow hedges that were discontinued prior to November 1, 2006 from
other assets to opening accumulated other comprehensive income.
Fair Value Hedges
Fair value hedges modify exposure to changes in a fixed rate instru-
ment’s fair value caused by changes in interest rates. These hedges
convert fixed rate assets and liabilities to floating rate. Our fair value
hedges include hedges of fixed rate commercial and personal loans,
securities, deposits and subordinated debt.
Under the new rules, we will continue to record interest receivable
or payable on the derivative as an adjustment to interest, dividend
and fee income in the Consolidated Statement of Income over the life
of the hedge.
For fair value hedges, not only is the hedging derivative recorded
at fair value but fixed rate assets and liabilities that are part of a
hedging relationship are adjusted for the changes in value of the risk
being hedged (quasi fair value). To the extent that the change in the
fair value of the derivative does not offset changes in the quasi fair value
adjustment to the hedged item (the ineffectiveness of the hedge), the
net amount is recorded directly in non-interest revenue, other in the
Consolidated Statement of Income. Gains on the ineffective portion of our
fair value hedges totalled $1 million for the year ended October 31, 2007.
For fair value hedges that are discontinued, we cease adjusting
the hedged item to quasi fair value. The quasi fair value adjust-
ment on the hedged item is recorded as an adjustment to the interest
income/expense on the hedged item over its remaining term to
maturity. If the hedged item is sold or settled, any remaining quasi fair
value adjustment is included in the determination of the gain or loss
on sale or settlement. We did not hedge any commitments during the
year ended October 31, 2007.
When we remeasured our fair value hedging derivatives at
fair value on November 1, 2006, we made a corresponding adjust-
ment to the carrying value of the items that we hedge with those
derivatives (quasi fair value adjustment). The difference between
these two amounts was recorded in opening retained earnings and
totalled less than $1 million. On November 1, 2006, we also reclassified
deferred amounts related to fair value hedges that were discontinued
prior to November 1, 2006 from other assets to adjust the carrying
amount of the items that were previously hedged. Quasi fair value
adjustments related to these two activities were comprised of an
increase in loans of $3 million, an increase in deposits of $38 million,
an increase in subordinated debt of $9 million and an increase in
other assets of $6 million.
Foreign Currency Risk
We manage foreign currency risk through cross-currency swaps. Cross-
currency swaps are marked to market, with realized and unrealized gains
and losses recorded in non-interest revenue, consistent with the account-
ing treatment for gains and losses on the economically hedged item.
We also periodically hedge U.S. dollar earnings through forward
foreign exchange contracts to minimize fluctuations in our Canadian
dollar earnings due to the translation of our U.S. dollar earnings.
These contracts are marked to fair value, with gains and losses recorded
as non-interest revenue in foreign exchange, other than trading.
BMO Financial Group 190th Annual Report 2007 109
Notes