Bank of Montreal 2010 Annual Report Download - page 132

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Notes
130 BMO Financial Group 193rd Annual Report 2010
compensation trusts amounted to $1,021 million as at October 31, 2010
($869 million in 2009). Based on our assessment of variable interests,
we are not required to consolidate these compensation trusts and
we have no exposure to loss related to these trusts.
Other VIEs
We are involved with other entities that may potentially be VIEs.
This involvement can include, for example, acting as a derivatives
counterparty, liquidity provider, investor, fund manager or trustee.
These activities do not cause us to be exposed to a majority of
the expected losses of these VIEs or allow us to benefit from a majority
of their expected residual returns. As a result, we are not required to
consolidate these VIEs. Transactions with these VIEs are conducted at
market rates, and individual creditor investment decisions are based
upon the analysis of the specific VIE, taking into consideration the quality
of underlying assets. We record and report these transactions in the
same manner as other transactions. For example, derivative contracts
are recorded in accordance with our derivatives accounting policy as
outlined in Note 10. Liquidity facilities are described in Note 7.
Note 10: Derivative Instruments
Derivative instruments are financial contracts that derive their value
from underlying changes in interest rates, foreign exchange rates or
other financial or commodity prices or indices.
Derivative instruments are either regulated exchange-traded
contracts or negotiated over-the-counter contracts. We use these
instruments for trading purposes, as well as to manage our exposures,
mainly to currency and interest rate fluctuations, as part of our asset/
liability management program.
Types of Derivatives
Swaps
Swaps are contractual agreements between two parties to exchange
a series of cash flows. The various swap agreements that we enter into
are as follows:
Interest rate swaps – counterparties generally exchange fixed
and floating rate interest payments based on a notional value in
a single currency.
Cross-currency swaps – fixed rate interest payments and principal
amounts are exchanged in different currencies.
Cross-currency interest rate swaps – fixed and floating rate interest
payments and principal amounts are exchanged in different currencies.
Commodity swaps – counterparties generally exchange fixed and
floating rate payments based on a notional value of a single commodity.
Equity swaps – counterparties exchange the return on an equity
security or a group of equity securities for the return based on a fixed
or floating interest rate or the return on another equity security or group
of equity securities.
Credit default swaps – one counterparty pays the other a fee
in exchange for that other counterparty agreeing to make a payment
if a credit event occurs, such as bankruptcy or failure to pay.
Total return swaps – one counterparty agrees to pay or receive
from the other cash amounts based on changes in the value of a
reference asset or group of assets, including any returns such as interest
earned on these assets, in exchange for amounts that are based on
prevailing market funding rates.
The main risks associated with these instruments are related to
exposure to movements in interest rates, foreign exchange rates, credit
quality, securities values or commodities prices, as applicable, and the
possible inability of counterparties to meet the terms of the contracts.
Forwards and Futures
Forwards and futures are contractual agreements to either buy or sell
a specified amount of a currency, commodity, interest-rate-sensitive
financial instrument or security at a specific price and date in the future.
Forwards are customized contracts transacted in the over-the-
counter market. Futures are transacted in standardized amounts on
regulated exchanges and are subject to daily cash margining.
The main risks associated with these instruments arise from the
possible inability of over-the-counter counterparties to meet the terms
of the contracts and from movements in commodities prices, securities
values, interest rates and foreign exchange rates, as applicable.
Options
Options are contractual agreements that convey to the purchaser
the right but not the obligation to either buy or sell a specified
amount of a currency, commodity, interest-rate-sensitive financial
instrument or security at a fixed future date or at any time within
a fixed future period.
For options written by us, we receive a premium from the
purchaser for accepting market risk.
For options purchased by us, we pay a premium for the right to
exercise the option. Since we have no obligation to exercise the option,
our primary exposures to risk are the ability to hedge the market risk
in a manner which allows us to recover the premium paid and the credit
risk if the writer of an over-the-counter contract fails to meet the terms
of the contract.
Caps, collars and floors are specialized types of written and
purchased options. They are contractual agreements in which the
writer agrees to pay the purchaser, based on a specified notional
amount, the difference between the market rate and the prescribed
rate of the cap, collar or floor. The writer receives a premium for
selling this instrument.
Uses of Derivatives
Trading Derivatives
Trading derivatives include derivatives entered into with customers
to accommodate their risk management needs, derivatives transacted
to generate trading income from our own proprietary trading positions
and certain derivatives that do not qualify as hedges for accounting
purposes (“economic hedges”).
We structure and market derivative products to enable customers
to transfer, modify or reduce current or expected risks.
Proprietary activities include market-making, positioning and
arbitrage activities. Market-making involves quoting bid and offer prices
to other market participants with the intention of generating revenues
based on spread and volume. Positioning activities involve managing
market risk positions with the expectation of profiting from favourable
movements in prices, rates or indices. Arbitrage activities involve
identifying and profiting from price differentials between markets
and products.
We may also take proprietary trading positions in various capital
market instruments and derivatives that, taken together, are designed
to profit from anticipated changes in market conditions.
Trading derivatives are marked to fair value. Realized and unrealized
gains and losses are recorded in trading revenues (losses) in our
Consolidated Statement of Income. Unrealized gains on trading derivatives
are recorded as derivative instrument assets and unrealized losses
are recorded as derivative instrument liabilities in our Consolidated
Balance Sheet.
Hedging Derivatives
In accordance with our asset/liability management strategy, we enter
into various derivative contracts to hedge our interest rate and foreign
currency exposures.