Bank of Montreal 2007 Annual Report Download - page 116

Derivative-Related Credit Risk
Over-the-counter derivative instruments are subject to credit risk.
Credit risk arises from the possibility that counterparties may default on
their obligations. The credit risk associated with derivatives is normally
a small fraction of the notional amount of the derivative instrument.
Derivative contracts generally expose us to potential credit loss if changes
in market rates affect a counterparty’s position unfavourably and the
counterparty defaults on payment. The credit risk is represented by the
positive fair value of the derivative instrument. We strive to limit credit
risk by dealing with counterparties that we believe are creditworthy,
and we manage our credit risk for derivatives using the same credit risk
process that is applied to loans and other credit assets.
We also pursue opportunities to reduce our exposure to credit
losses on derivative instruments, including entering into master netting
agreements with counterparties. The credit risk associated with favour-
able contracts is eliminated by master netting agreements, to the
extent that unfavourable contracts with the same counterparty cannot
be settled before favourable contracts.
Exchange-traded derivatives have no potential for credit exposure
as they are settled net with each exchange.
Terms used in the credit risk table below are as follows:
Replacement cost represents the cost of replacing all contracts that have
a positive fair value, using current market rates. It represents in effect
the unrealized gains on our derivative instruments. Replacement costs
disclosed below represent the net of the asset and liability to a specific
counterparty where we have a legally enforceable right to offset the
amount owed to us with the amount owed by us and we 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 plus
an amount representing the potential future credit exposure, as outlined
in the Capital Adequacy Guideline of the Superintendent of Financial
Institutions Canada.
Risk-weighted balance represents the credit risk equivalent, weighted
based on the creditworthiness of the counterparty, as prescribed by the
Superintendent of Financial Institutions Canada.
112 BMO Financial Group 190th Annual Report 2007
Notes to Consolidated Financial Statements
Notes
(Canadian $ in millions) 2007 2006
Replacement Credit risk Risk-weighted Replacement Credit risk Risk-weighted
cost equivalent balance cost equivalent balance
Interest Rate Contracts
Swaps $ 7,343 $ 13,314 $ 2,959 $ 7,405 $ 12,491 $ 2,858
Forward rate agreements 13 13 4 114 125 27
Purchased options 1,050 1,352 305 1,257 1,620 363
Total interest rate contracts 8,406 14,679 3,268 8,776 14,236 3,248
Foreign Exchange Contracts
Cross-currency swaps 1,997 2,650 764 1,408 2,041 548
Cross-currency interest rate swaps 7,203 11,560 2,132 3,076 6,478 1,179
Forward foreign exchange contracts 4,842 6,311 1,624 797 2,233 595
Purchased options 244 318 121 63 129 44
Total foreign exchange contracts 14,286 20,839 4,641 5,344 10,881 2,366
Commodity Contracts
Swaps 2,220 8,535 3,016 3,713 11,532 4,130
Purchased options 3,056 10,457 3,419 5,717 16,012 5,483
Total commodity contracts 5,276 18,992 6,435 9,430 27,544 9,613
Equity Contracts 1,318 2,902 902 312 1,963 662
Credit Contracts 642 4,721 1,134 169 2,372 542
Total derivatives 29,928 62,133 16,380 24,031 56,996 16,431
Impact of master netting agreements (16,403) (29,541) (7,467) (16,644) (30,655) (8,889)
Total $ 13,525 $ 32,592 $ 8,913 $ 7,387 $ 26,341 $ 7,542
Included in the 2006 total are unrealized gains on hedging derivatives, which we include in
the Consolidated Balance Sheet on an accrual rather than a mark-to-market basis. The excess
of market value over book value for these items was $70 million as at October 31, 2006.
The total derivatives and impact of master netting agreements for replacement cost do not include
exchange-traded derivatives with a positive fair value of $2,657 million as at October 31, 2007
($6,450 million in 2006).
Transactions are conducted with counterparties in various geographic locations and industries. Set out below is the replacement cost of contracts
(before the impact of master netting agreements) with customers located in the following countries, based on country of ultimate risk:
(Canadian $ in millions, except as noted) 2007 2006
Canada $ 11,686 39% $ 6,598 28%
United States 10,867 36 11,402 47
Other countries (1) 7,375 25 6,031 25
Total $ 29,928 100% $ 24,031 100%
(1) No other country represented 10% or more of our replacement cost in either 2007 or 2006.