Bank of Montreal 2008 Annual Report Download - page 84

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
80 | BMO Financial Group 191st Annual Report 2008
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 at the start of each quarter that are
expected to partially offset the pre-tax effects of Canadian/U.S. dollar
exchange rate fluctuations in the quarter on the expected U.S. dollar
net income for the quarter.
BMO’s U.S.-dollar-denominated results are affected, favourably or
unfavourably, by movements in the Canadian/U.S. dollar exchange rate.
Rate movements affect future results measured in Canadian dollars
and the impact on results is a function of the periods in which revenues,
expenses and provisions for credit losses arise. If future results are con-
sistent with the range of the past three years, U.S.-dollar-denominated
income before income taxes would range from a loss of US$900 million
to income of US$700 million. On that basis, each one cent decrease
in the Canadian/U.S. dollar exchange rate, expressed in terms of how
many Canadian dollars one U.S. dollar buys, would be expected to
change net income before income taxes by between $9 million at the
lower end of the range and –$7 million at the higher end. An increase
of one cent would have the opposite effect.
Structural MVE and EV measures both reflect holding periods of
between one and three months and incorporate the impact of correla-
tion between market variables.
Structural MVE increased in fiscal 2008 primarily as a result of
growth in common shareholders’ equity. EV continues to be managed to
low levels.
In addition to MVE and EV, we use simulations, sensitivity analysis,
stress testing and gap analysis to measure and manage interest rate
risk. Gap analysis is disclosed in Note 20 on page 133 of the
financial statements.
Structural interest rate sensitivity to an immediate parallel increase
or decrease of 100 and 200 basis points in the yield curve is disclosed in
the table below. This sensitivity analysis is performed and disclosed by
many financial institutions and facilitates comparison with our
peer group.
Structural Interest Rate Sensitivity ($ millions)*
After-tax Canadian equivalent As at October 31, 2008 As at October 31, 2007
Economic 12-month Economic 12-month
value earnings value earnings
sensitivity sensitivity sensitivity sensitivity
100 basis point increase (220.8) (4.4) (201.1) 6.6
100 basis point decrease 169.2 (21.0) 138.6 (15.4)
200 basis point increase (488.6) (16.2) (438.1) 0.4
200 basis point decrease 328.4 (177.6) 234.0 (17.0)
*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 cus-
tomers would likely react to the changes. For customer loans and
deposits with scheduled maturity and repricing dates (such as mort-
gages 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 (such as credit
card loans and chequing accounts), our models impute a maturity pro-
file that considers pricing and volume strategies and is reflective of the
associated uncertainties. These models have been developed using sta-
tistical 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.
i
SEE PG 73
i
SEE PG 73
i
SEE PG 73
i
SEE PG 73
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.
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 derivatives. 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 duration, which
is currently between two and three years, while embedded options are
managed to low risk levels. The net interest rate mismatch is primarily
managed with interest rate swaps and securities. Embedded option risk
exposures are managed by purchasing options or through a dynamic
hedging process.
0
5
10
15
20
25
30
(182)
(105)
(90)
(67)
(62)
(56)
(36)
(30)
(24)
(18)
(15)
(12)
(9)
(8)
(7)
(6)
(5)
(4)
(3)
(2)
0
1
2
3
4
5 6
7
8
9
10
13
27
32
37
41
61
66
22
17
111
228
Frequency Distribution of Daily Net Revenues
November 1, 2007 to October 31, 2008 ($ millions)
Daily net revenues (pre-tax)
Frequency in number of days
The distribution of our daily net revenue for the portfolios has been
affected by periodic valuation adjustments as outlined in the notes to
the preceding Trading and Underwriting Net Revenues versus Market
Value Exposure graph.
(40)
(35)
(30)
(25)
(20)
(15)
(10)
(5)
0
Risk Factors
November 1, 2007 to October 31, 2008 ($ millions)
Interest Rate Risk (MTM)
Foreign Exchange Risk
Issuer Risk
Commodity Risk
Equity Risk
Interest Rate Risk (accrual)