Bank of Montreal 2008 Annual Report Download - page 82

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
78 | BMO Financial Group 191st Annual Report 2008
MVE and EV for Trading and Underwriting
and Structural Positions
($ millions) *
Market 12-month Market 12-month
As at October 31 value earnings value earnings
(After-tax Canadian equivalent) exposure volatility exposure volatility
2008 2008 2007 2007
Trading and Underwriting (33.4) (28.7) (18.2) (12.6)
Structural (267.9) (30.2) (231.6) (24.2)
* Measured at a 99% confidence interval.
Trading and underwriting MVE and EV increased over the past year
primarily as a result of higher observed market volatilities for interest
rates and credit spreads. Structural MVE increased over the prior year
primarily due to growth in common shareholders’ equity. EV continues
to be managed to low levels.
Trading and Underwriting Market Risk
BMO’s Market Risk group provides oversight of trading and underwriting
portfolios by ensuring:
•market risk of trading and underwriting portfolios is measured and
modelled in compliance with corporate policies and standards;
•risk profiles of our trading and underwriting portfolios are maintained
within our risk appetite, and are monitored and reported to traders,
senior executives, management and Board committees;
•proactive identification and reporting to senior executives, manage-
ment and Board committees of specific exposures or other factors that
expose BMO to unusual, unexpected, inappropriate or otherwise not
fully identified or quantified risks associated with market or traded
credit exposures;
•all individuals authorized to execute trading and underwriting
transactions on behalf of BMO are appropriately informed of BMO’s
risk-taking governance, authority structure, procedures and processes
by providing access to and guidance on the relevant corporate
policies and standards.
To capture the multi-dimensional aspects of market risk effectively,
a number of metrics are used including VaR, stress testing, option
sensitivities, position concentrations, market and notional values and
revenue losses.
VaR and stress testing are portfolio estimates of risk but are not
without their limitations. Some limitations of VaR are its assumption
that all positions can be liquidated within the assigned one-day holding
period (ten-day holding period for regulatory calculations), which may
not be the case in illiquid market conditions, and that historical data
can be used as a proxy to predict future market events. Scenario analysis
and probabilistic stress testing are performed daily 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 lines
of business, Trading Products Risk Committee, Risk Management
Committee and Risk Review Committee on a regular basis. Stress testing
is limited by the number of scenarios that can be run, and by the fact
that not all downside scenarios can be predicted and effectively
modelled. Neither VaR nor stress testing are viewed as predictors of the
maximum amount of losses that could occur in any one day, because
both measures are computed at prescribed confidence levels and could
be exceeded in highly volatile market conditions. On a daily basis,
exposures are aggregated by lines of business and risk type and
monitored against delegated limit levels, and the results are reported
to the respective stakeholders. All risk exposures that exceed their
respective delegated limits are escalated to senior management for
resolution in a timely manner. The business in question is required
to either bring the exposure to within limits, or consult with Market
Risk on the appropriate action to be taken.
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SEE PG 73
Within Market Risk, the Valuation Product Control group checks
whether the valuations of all trading and underwriting portfolios within
BMO are materially accurate by:
•developing and maintaining valuation adjustment/reserve
policies and issuer risk procedures in accordance with regulatory
requirements and GAAP;
•establishing official rate sources for valuation of mark-to-market
portfolios; and
•providing an independent review of trading books where trader
prices are used for valuation of mark-to-market portfolios.
BMO’s Independent Price Verification process is used to validate
valuations derived from trader inputs. Trader valuations are reviewed
to ensure they align with an independent assessment of the
market value of the portfolio. If the valuation differences exceed
the prescribed tolerance threshold, a valuation adjustment is
implemented in accordance with accounting policy and regulatory
requirements. Prior to the final month-end general ledger close,
meetings are held between the line of business, Market Risk, Capital
Markets Finance and Accounting Policy to obtain concurrence on
all valuation reserves and adjustments.
At minimum, the following major categories of valuation
reserves are considered when determining appropriate valuation
adjustment/reserve levels: credit spreads, close-out costs, administra-
tive costs, liquidity and model risk. Also, a fair value hierarchy is
used to categorize the inputs used in valuation techniques in the
valuation of securities, fair value liabilities, derivative assets and
derivative liabilities. Level 1 covers the use of quoted market prices
in the fair valuation process, Level 2 covers internal models with
observable market information and Level 3 covers internal models
without observable market information. Details of Level 1, Level 2
and Level 3 fair valuation measurements can be found in the Critical
Accounting Estimates section on page 69.
Market Value Exposure (MVE) is a measure of the adverse impact
of changes in market parameters on the market value of a port-
folio of assets, liabilities and off-balance sheet positions, measured
at a 99% confidence level over a specified holding period. The
holding period considers current market conditions and composition
of the portfolios to determine how long it would take to neutralize
the market risk without adversely affecting market prices. For
trading and underwriting activities, MVE is comprised of Value at
Risk and Issuer Risk.
Earnings Volatility (EV) is a measure of the adverse impact
of potential changes in market parameters on the projected
12-month after-tax net income of a portfolio of assets, liabilities
and off-balance sheet positions, measured at a 99% confidence
level over a specified holding period.
Value at Risk (VaR) is measured for specific classes of risk
in BMO’s trading and underwriting activities: interest rate, foreign
exchange rate, equity and commodity prices and their implied
volatilities. This measure calculates the maximum likely loss from
portfolios, over a specified holding period, measured at a 99%
confidence level.
Issuer Risk arises in BMO’s trading and underwriting portfolios,
and measures the adverse impact of credit spread, credit migration
and default risks on the market value of fixed income instruments
and similar securities. Issuer risk is measured at a 99% confidence
level over
a specified holding period.