Bank of Montreal 2015 Annual Report Download - page 144

Notes
Trading Derivatives
Trading derivatives include derivatives entered into with customers to accommodate their risk management needs, market-making to facilitate
customer-driven demand for derivatives, derivatives transacted on a limited basis to generate trading income from our principal trading positions and
certain derivatives that are executed as part of our risk management strategy 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.
Principal trading activities include market-making and positioning 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.
Trading derivatives are recorded at fair value. Realized and unrealized gains and losses are recorded in trading revenues 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 risk management strategy, we enter into various derivative contracts to hedge our interest rate and foreign currency
exposures.
We may also economically hedge a portion of our U.S. dollar earnings through forward foreign exchange contracts to minimize fluctuations in our
consolidated net income due to the translation of our U.S. dollar earnings. These contracts are recorded at fair value, with changes in fair value
recorded in non-interest revenue in our Consolidated Statement of Income.
Accounting Hedges
In order for a derivative instrument 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 changes in the fair
value or changes in the amount of future cash flows of the hedged item.
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 interest rate bearing instruments, foreign currency denominated assets and
liabilities and certain cash-settled share-based payment grants subject to equity price risk. Variable interest rate bearing instruments include floating
rate loans and deposits. Our cash flow hedges have a maximum remaining term to maturity of 20 years.
We record interest that we pay or receive on these cash flow hedge derivatives as an adjustment to net interest 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. The excess 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 cumulative unrealized gain or loss recorded in other
comprehensive income is amortized to our Consolidated Statement of Income in net interest income for interest rate swaps and in employee
compensation for total return swaps as the hedged item is recorded in earnings. If the hedged item is sold or settled, the entire unrealized gain or
loss is recognized immediately in net interest income 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 $166 million
($122 million after tax). This will adjust the interest income and interest expense recorded on assets and liabilities and employee compensation
expense that were hedged.
BMO Financial Group 198th Annual Report 2015 157