TD Bank 2001 Annual Report Download - page 30

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HOW WE PERFORMED IN 2001
MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATING PERFORMANCE
Managing interest rate risk
Interest rate risk is the impact changes in interest rates
could have on our margins, earnings and economic value.
Rising interest rates could, for example, increase our funding
costs, which would reduce the net interest income earned
on certain loans.
We are exposed to interest rate risk when asset and liability
principal and interest cash flows have different interest payment
or maturity dates. These are called “mismatched positions”. An
interest-sensitive asset or liability is repriced when interest rates
change or when there is cash flow from final maturity, normal
amortization or when customers exercise prepayment,
conversion or redemption options.
Our exposure depends on the size and direction of interest
rate changes, and on the size and maturity of the mismatched
positions. It is also affected by new business volumes, renewals
of loans and deposits, and how actively customers exercise
options like prepaying or redeeming a loan or deposit before its
maturity date.
We manage interest rate risk within limits set by our interest
rate risk management policies.
We perform valuations of all asset and liability positions as
well as all off-balance sheet exposures every week, and value
certain option positions daily. We then hedge the resulting
financial position to a target risk profile. We use derivative
financial instruments, wholesale instruments and other capital
market alternatives and, less frequently, product pricing
strategies to manage interest rate risk.
Within the financial position, we measure and manage
interest rate risk exposure from instruments with closed (non-
optioned) fixed-rate cash flows separately from product options.
Product options represent a significant financial risk, whether
they are free-standing, such as mortgage rate commitments, or
embedded in loans or deposits.
Interest rate risk exposure from closed (non-optioned) instru-
ments exhibits an almost linear or symmetrical payoff profile to
parallel changes in interest rates. The graph below shows our
interest rate risk exposure on October 31, 2001 on the closed
(non-optioned) instruments within the financial position. If this
portfolio had experienced an immediate and sustained 100 basis
point decrease in rates on October 31, 2001, the economic
value of shareholders’ equity would have decreased by $9 million
after tax ($2 million in 2000 for a 100 basis point increase in
rates). This same shock would reduce net income after tax by
$6 million over the next 12 months ($7 million in 2000).
Exposure to interest rate risk from product options exhibits
non-linear or asymmetrical payoff profiles. The graph below
shows our interest rate risk exposure on October 31, 2001 on
all instruments within the financial position –the closed (non-
optioned) instruments plus product options. An immediate
and sustained 100 basis point decrease in rates would have
decreased the economic value of shareholders’equity by
$40 million after tax ($25 million in 2000 for a 100 basis point
increase in rates).
We manage the risk of product options by buying options or
through a dynamic hedging process designed to replicate the
payoff of a purchased option. Dynamic hedging involves
rebalancing the hedging instruments we hold for small changes
in interest rates. The graph below assumes that the dynamic
hedging portfolios held on October 31 are not rebalanced for the
interest rate shock.
Managing foreign exchange risk
Foreign exchange risk refers to losses that could result from
changes in foreign currency exchange rates. Assets and
liabilities that are denominated in foreign currencies have
foreign exchange risk.
We are exposed to foreign exchange risk:
•when our foreign currency assets are greater or less than our
liabilities in that currency. This creates a foreign currency
open position. We minimize our foreign currency open
positions to manage this risk.
•from our investments in foreign operations. We manage this
risk to a target risk profile that includes minimizing the risk
that changes in foreign currency exchange rates will adversely
affect our capital ratios.
LIQUIDITY RISK
Liquidity risk is the risk that we cannot meet a demand for
cash or fund our obligations as they come due. Demand for
cash can come from withdrawals of deposits, debt maturities
and commitments to provide credit.
We hold sufficient liquid assets in Canadian and U.S. dollars as
well as other foreign currencies so that funds can quickly be
TOTAL FINANCIAL POSITION
ECONOMIC VALUE AT RISK BY INTEREST RATE SHOCK1
(millions of dollars as of October 31, 2001)
Changes in present value after tax
Parallel interest rate shock (basis points)
-200 -150 -100 -50 0 50 100 150 200
-150
-125
-100
-75
-50
-25
0
25
CLOSED (NON-OPTIONED) INSTRUMENTS PORTFOLIO
ECONOMIC VALUE AT RISK BY INTEREST RATE SHOCK1
(millions of dollars as of October 31, 2001)
Changes in present value after tax
Parallel interest rate shock (basis points)
-200 -150 -100 -50 0 50 100 150 200
-40
-20
0
20
1The interest rate risk exposure of non-maturity deposits and loans is
measured based on assumed maturity profiles.