Bank of Montreal 2010 Annual Report Download - page 133

Notes
BMO Financial Group 193rd Annual Report 2010 131
Risks Hedged
Interest Rate Risk
We manage interest rate risk through interest rate swaps and options,
which are linked to and adjust the interest rate sensitivity of a spe-
cific asset, liability, forecasted transaction or firm commitment, or a
specific pool of transactions with similar risk characteristics.
Foreign Currency Risk
We manage foreign currency risk through cross-currency swaps and
forward contracts. These derivatives are marked to fair value , with
realized and unrealized gains and losses recorded in non-interest revenue,
consistent with the accounting treatment for gains and losses on the
economically hedged item. Changes in fair value on forward contracts
that qualify as accounting hedges are recorded in other comprehensive
income, with the spot/forward differential (the difference between
the foreign currency rate at inception of the contract and the rate at the
end of the contract) being recorded in interest expense over the term
of the hedge.
We also sometimes economically hedge U.S. dollar earnings through
forward foreign exchange contracts to minimize fluctuations in our
Canadian dollar earnings due to the translation of our U.S. dollar earnings.
These contracts are marked to fair value, with gains and losses recorded
as non-interest revenue in foreign exchange, other than trading.
Accounting Hedges
In order for a derivative to qualify as an accounting hedge, the
hedging relationship must be designated and formally documented
at its inception, detailing the particular risk management objective
and strategy for the hedge and the specific asset, liability or cash flow
being hedged, as well as how its effectiveness is being assessed.
Changes in the fair value of the derivative must be highly effective
in offsetting either changes in the fair value of on-balance sheet
items caused by the risk being hedged or changes in the amount
of future cash flows.
Hedge effectiveness is evaluated at the inception of the hedging
relationship and on an ongoing basis, retrospectively and prospectively,
primarily using quantitative statistical measures of correlation. Any
ineffectiveness in the hedging relationship is recognized in non-interest
revenue, other in our Consolidated Statement of Income as it arises.
Cash Flow Hedges
Cash flow hedges modify exposure to variability in cash flows for
variable rate interest bearing instruments and assets denominated in
foreign currencies. Our cash flow hedges, which have a maximum
remaining term to maturity of seven years, are hedges of floating rate
loans and deposits as well as assets denominated in foreign currencies.
We record interest that we pay or receive on the derivative as an
adjustment to interest, dividend and fee income in our Consolidated
Statement of Income over the life of the hedge.
To the extent that changes in the fair value of the derivative offset
changes in the fair value of the hedged item, they are recorded in other
comprehensive income. Any portion of the change in fair value of the
derivative that does not offset changes in the fair value of the hedged
item (the “ineffectiveness of the hedge”) is recorded directly in
non-interest revenue, other in our Consolidated Statement of Income.
For cash flow hedges that are discontinued before the end of
the original hedge term, the unrealized gain or loss recorded in other
comprehensive income is amortized to interest, dividend and fee
income or interest expense, as applicable, in our Consolidated Statement
of Income as the hedged item affects earnings. If the hedged item
is sold or settled, the entire unrealized gain or loss is recognized in
interest, dividend and fee income or interest expense, as applicable,
in our Consolidated Statement of Income. The amount of unrealized gain
that we expect to reclassify to our Consolidated Statement of Income
over the next 12 months is $138 million ($96 million after tax). This will
adjust interest on assets and liabilities that were hedged.
Fair Value Hedges
Fair value hedges modify exposure to changes in a fixed rate instru-
ment’s
fair value caused by changes in interest rates. These hedges
convert fixed rate assets and liabilities to floating rate. Our fair value
hedges include hedges of fixed rate securities, deposits and subordi-
nated debt.
We record interest receivable or payable on the derivative as
an adjustment to net interest income in our Consolidated Statement
of Income over the life of the hedge.
For fair value hedges, not only is the hedging derivative recorded
at fair value but fixed rate assets and liabilities that are part of a hedging
relationship are adjusted for the changes in value of the risk being
hedged (“quasi fair value”). To the extent that the change in the fair
value of the derivative does not offset changes in the quasi fair value
of the hedged item (the “ineffectiveness of the hedge”), the net
amount is recorded directly in non-interest revenue, other in our
Consolidated Statement of Income.
For fair value hedges that are discontinued, we cease adjusting
the hedged item to quasi fair value. The quasi fair value adjustment
of the hedged item is then amortized as an adjustment to the interest
income/expense on the hedged item over its remaining term to
maturity. If the hedged item is sold or settled, any remaining quasi fair
value adjustment is included in the determination of the gain or loss
on sale or settlement. We did not hedge any commitments during the
years ended October 31, 2010 and 2009.
Net Investment Hedges
Net investment hedges mitigate our exposure to foreign currency
fluctuations in our net investment in foreign operations. Deposit liabilities
denominated in foreign currencies are designated as hedges of this
exposure. The foreign currency translation of both the net investment and
hedge is recorded in Accumulated Other Comprehensive Income (Loss)
on Translation of Net Foreign Operations. To the extent that the hedge
is not effective, amounts are included in the Consolidated Statement of
Income in foreign exchange, other than trading. The amount of hedge
ineffectiveness associated with net investment hedges for the year
ended October 31, 2010 was a gain of $4 million (gain of $10 million
in 2009 and loss of $11 million in 2008).