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Management’s Discussion and Analysis
70 BMO Financial Group 190th Annual Report 2007
MD&A
duration, which is currently between two and three years, while
embedded options are managed to low risk levels. The interest rate
mismatch is primarily managed with interest rate swaps and securities.
Embedded option exposures are managed by purchasing options or
through a dynamic hedging process.
Structural foreign exchange risk arises primarily from translation
risk associated with the net investment in our U.S. operations, and from
transaction risk associated with our U.S.-dollar-denominated net income.
Translation risk is managed by funding our net U.S. investment in U.S.
dollars. Transaction risk is managed by entering into foreign exchange
forward contract hedges each quarter that are expected to partially
offset the effects of Canadian/U.S. dollar exchange rate fluctuations on
the quarter’s net income. The impact of exchange rate fluctuations on
BMO’s 2007 net income is reviewed on page 35.
Structural MVE and EV measures both reflect holding periods of
between one and three months and incorporate the impact of correlation
between market variables. Structural MVE (see page 68) has decreased
in fiscal 2007 as a result of lower modelled interest rate volatility.
Interest rate volatility is derived from 10 years of historical data that
in fiscal 2007 excludes the high volatility associated with fiscal 1997.
EV continues to be managed to low levels.
In addition to MVE and EV, we use simulations, sensitivity analysis,
stress testing and gap analysis to measure and manage interest
rate risk. Gap analysis is disclosed in Note 20 on page 119 of the finan-
cial statements.
Structural interest rate sensitivity to an immediate parallel
increase or decrease of 100 and 200 basis points in the yield curve is
disclosed in the table below. This sensitivity analysis is performed and
disclosed by many financial institutions and facilitates comparison
with our peer group.
Structural Interest Rate Sensitivity ($ millions)*
After-tax Canadian equivalent As at October 31, 2007 As at October 31, 2006
Economic 12 month Economic 12-month
value earnings value earnings
sensitivity sensitivity sensitivity sensitivity
100 basis point increase
(241.1) 6.6 (237.4) 10.9
100 basis point decrease
180.1 (15.4) 181.6 (10.5)
200 basis point increase
(516.6) 0.4 (508.0) 12.1
200 basis point decrease
318.6 (17.0) 318.3 (4.1)
*Exposures are in brackets and benefits are represented by positive amounts.
Models used to measure structural market risk project how interest
rates and foreign exchange rates may change and predict how
customers would likely react to the changes. For customer loans and
deposits with scheduled maturity and repricing dates (e.g. mortgages
and term deposits), our models measure how customers use embedded
options to modify those terms. For customer loans and deposits
without scheduled maturity and repricing dates (e.g. credit card loans
and chequing accounts), our models impute a maturity profile that
considers pricing and volume strategies and is reflective of the
associated uncertainties. These models have been developed using
statistical analysis and are validated through regular model vetting
and backtesting processes and ongoing dialogue with the lines
of business. Models used to predict consumer behaviour are also
used in support of product pricing and performance measurement.
Trading revenues include amounts from all trading and underwriting
activities, whether accounted for on a mark-to-market basis or an accrual
basis, as well as certain fees and commissions directly related to
those activities.
We use a variety of methods to ensure the integrity of our risk
models, including the application of backtesting against hypothetical
losses. This process assumes there are no changes in the previous day’s
closing positions. The process then isolates the effects of each day’s
price movements against these closing positions. Models are validated
by assessing how often the calculated hypothetical losses exceed the
MVE measure over a defined period. Results of this testing confirm the
reliability of our models.
The models used to measure market risks are effective at meas-
uring risks under normal market conditions. In addition, we perform
scenario analysis and probabilistic stress testing on a daily basis to
determine the impact of unusual and/or unexpected market changes
on our portfolios. As well, historical and event stresses are tested on
a weekly basis. Scenarios are amended, added or deleted, to better
reflect changes in underlying market conditions. The results are reported
to the line of business, MRC, RMC and RRC on a regular basis.
Structural Market Risk
Structural market risk is comprised of interest rate risk arising from
our banking activities (loans and deposits) and foreign exchange risk
arising from our foreign currency operations. Structural market risk
is managed by BMO’s Corporate Treasury in support of stable, high-quality
earnings, and maximization of sustainable product spreads.
Structural interest rate risk arises primarily from interest rate
mismatches and embedded options. Interest rate mismatches result
from
differences in the scheduled maturity or repricing dates of assets,
liabilities
and off-balance sheet items. Embedded option risk results
from product features that allow customers to modify scheduled
maturity or repricing dates. Embedded options include loan prepayment
and deposit redemption privileges and committed rates on unadvanced
mortgages. The net interest rate mismatch, representing residual
assets funded by common shareholders’ equity, is managed to a target
5
10
15
20
25
30
(510)
(250)
(115)
(80)
(34)
(30)
(23)
(13)
(12)
(11)
(10)
(9)
(8)
(7)
(6)
(5)
(4)
(3)
(2)
(1)
0
1
2
3
4
5
6
7
8
9
10
11
14
15
16
17
18
20
13
12
180
228
Frequency Distribution of Daily Net Revenues
November 1, 2006 to October 31, 2007 ($ millions)
Daily net revenues (pre-tax)
Frequency in number of days
The distribution of our daily net revenue for the portfolios has been
impacted by restatements to our commodities business and periodic
valuation adjustments as outlined in the notes to the preceding Trading
and Underwriting Net Revenues versus Market Value Exposure graph.