Bank of Montreal 2008 Annual Report Download - page 130

Notes
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
126 | BMO Financial Group 191st Annual Report 2008
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
favourable 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.
Derivative-Related Market Risk
Derivative instruments are subject to market risk. Market risk arises
from the potential for a negative impact on the balance sheet and/or
income statement resulting from adverse changes in the value of
derivative instruments as a result of changes in certain market vari ables.
These variables include interest rates, foreign exchange rates, equity
and commodity prices and their implied volatilities, as well as credit
spreads, credit migration and default. We strive to limit market risk
by employing comprehensive governance and management processes
for all market risk-taking activities.
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 OSFI’s Capital Adequacy Guideline.
Risk-weighted balance represents the credit risk equivalent,
weighted based on the creditworthiness of the counterparty, as
prescribed by OSFI.
(Canadian $ in millions) 2008 2007
Replacement Credit risk Risk-weighted Replacement Credit risk Risk-weighted
cost equivalent balance (1) cost equivalent balance (1)
Interest Rate Contracts
Swaps $ 27,240 $ 34,264 $ – $ 7,343 $ 13,314 $ –
Forward rate agreements 165 180 – 13 13 –
Purchased options 1,714 2,057 – 1,050 1,352 –
Total interest rate contracts 29,119 36,501 3,921 8,406 14,679 3,268
Foreign Exchange Contracts
Cross-currency swaps 1,212 2,017 – 1,997 2,650 –
Cross-currency interest rate swaps 7,867 14,551 – 7,203 11,560 –
Forward foreign exchange contracts 8,383 9,928 – 4,842 6,311 –
Purchased options 398 576 – 244 318 –
Total foreign exchange contracts 17,860 27,072 3,362 14,286 20,839 4,641
Commodity Contracts
Swaps 2,336 8,242 – 2,220 8,535 –
Purchased options 1,670 7,037 – 3,056 10,457 –
Total commodity contracts 4,006 15,279 1,957 5,276 18,992 6,435
Equity Contracts 1,996 3,264 907 1,024 2,902 902
Credit Default Swaps
Purchased 6,435 7,564 4,750 642 4,721 1,134
Written ––––––
Total credit default swaps 6,435 7,564 4,750 642 4,721 1,134
Total derivatives 59,416 89,680 14,897 29,634 62,133 16,380
Impact of master netting agreements (41,748) (54,223) – (16,403) (29,541) (7,467)
Total $ 17,668 $ 35,457 $ 14,897 $ 13,231 $ 32,592 $ 8,913
(1)Risk-weightedbalancebasedonBaselIIin2008andBaselIin2007.
The total derivatives and impact of master netting agreements for replacement cost do not include
exchange-traded derivatives with a positive fair value of $6,170 million as at October 31, 2008
($2,951 million in 2007).
Certain comparative figures have been reclassified to conform with the current year’s presentation.
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) 2008 2007
Canada $ 21,022 36% $ 11,393 38%
United States 17,351 29 10,866 37
United Kingdom 8,411 14 1,776 6
Other countries (1) 12,632 21 5,599 19
Total $ 59,416 100% $ 29,634 100%
(1)Noothercountryrepresented10%ormoreofourreplacementcostineither 2008 or 2007. Certain comparative figures have been reclassified to conform with the current year’s presentation.