TD Bank 2001 Annual Report Download - page 28

26
HOW WE PERFORMED IN 2001
MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATING PERFORMANCE
MARKET RISK
Market risk is the potential for loss from changes in the
value of financial instruments.
The value of a financial instrument can be affected by
changes in:
•interest rates
•foreign exchange rates
•equity and commodity prices
•credit spreads.
We are exposed to market risk when we enter into financial
transactions through our four main trading activities:
•Market-making. We make markets for a large number of
securities and other traded products. We keep an inventory of
these securities to buy and sell with investors. We profit from
the spread between bid and ask prices. Profitability is driven
by trading volume.
•Sales. We provide a wide variety of financial products to meet
the needs of our clients. We earn money on these products
from price mark-ups or commissions. Profitability is driven by
sales volume.
•Arbitrage. We take positions in certain markets and offset the
risk in other markets. Our knowledge of various markets and
how they relate to each other allows us to identify and benefit
from pricing anomalies.
•Positioning. We aim to make profits by taking positions in
certain financial markets in anticipation of changes in those
markets. This is the riskiest of our trading activities and we
use it selectively.
Who manages market risk
Group Risk Management oversees market risk management for
our trading businesses. It is not accountable for trading
revenues. Its responsibilities include:
•designing and implementing methods for measuring and
reporting market risk
•approving new or additional trading limits
•monitoring exposure and approving any excesses compared
with the approved limits
•approving all new trading products
•independent testing of all pricing models and trading systems
•approving all market rates and prices used in valuing TD’s
trading positions and estimating market risk
•stress testing the portfolio to determine the effect of large,
unusual market movements
•implementing and maintaining the models used to calculate
regulatory capital required for market risk.
The Market Risk Policy Group within Group Risk Management
is responsible for measuring, reporting and monitoring market
risk, as well as communicating and enforcing risk limits
throughout our trading businesses. It also maintains the Market
Risk Policy Manual, which contains all policies relating to
market risk in the trading businesses.
The Market Risk Policy Committee meets every two weeks for
a peer review of the market risk profile of our trading businesses
and to approve changes to risk policies. The committee is
co-chaired by the Chairman and CEO, TD Securities and the
Senior Vice President, Market Risk Policy and includes members
of senior management of TD Securities and Internal Audit.
The Audit and Risk Management Committee of the Board of
Directors reviews market risk quarterly and approves all major
market risk policies annually.
How we manage market risk
Managing market risk is a key part of our business planning
process. We begin new trading operations and expand existing
ones only if:
•the risk has been thoroughly assessed and is judged to be
within our risk capacity and business expertise
•we have the infrastructure in place to monitor, control and
manage the risk.
We manage market risk primarily by setting trading limits and
by “stress testing” our trading activities.
Trading limits
Value at Risk (VaR) measures the adverse impact that potential
changes in market rates and prices could have on the value of a
portfolio over a specified period of time.
We set trading limits that are consistent with the approved
business plan for each business and our tolerance for the
market risk of that business. When setting these limits, we
consider market volatility, market liquidity, trader experience
and business strategy.
Our primary measure for setting trading limits is VaR. We use
VaR to monitor and control overall risk levels and to calculate
the regulatory capital required.
We may also apply specialized limits, such as notional limits,
credit spread limits, yield curve shift limits, loss exposure limits,
stop loss limits and other limits, if it’s appropriate to do so.
These additional limits reduce the likelihood that trading losses
will exceed VaR limits.
At the end of every day, Group Risk Management reviews
daily trading exposure reports and compares the risks with their
limits. If a trading limit has been exceeded, the trading desk
must immediately bring the position within the limit, unless Group
Risk Management approves an exception. It follows an estab-
lished process for approving exceptions to established limits.
If, during the day, it appears that a trading limit will be
exceeded, the trader must receive approval before carrying the
position overnight.
Calculating VaR
First we estimate VaR by creating a distribution of potential
changes in the market value of the current portfolio. We value
the current portfolio using the most recent 259 trading days of
market price and rate changes. Then we calculate the VaR so
that potential portfolio losses are expected to be less than the
VaR amount for 99 out of every 100 trading days.