TD Bank 2003 Annual Report Download - page 40

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. Our objective is to preserve or immunize
the present value of the margin booked at the time of inception
for fixed rate assets and liabilities and to reduce the volatility of
net interest income over time. Our approach is to value the assets
and liabilities by discounting future cash flows at a yield curve
indicative of the blended cost or credit of funds for each asset
or liability portfolio. The resulting net present value incorporates
the present value of margins booked. We then hedge the result-
ing financial position to the target risk profile of minimal residual
economic exposure. 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. Instruments
in the closed book exhibit the traditional, almost linear or
symmetrical payoff profile to parallel changes in interest rates
(i.e. asset values increase as rates fall and decrease as rates rise).
Included in future cash flows are modeled exposures for:
•An assumed maturity profile for the Bank’s core deposit
portfolio; and
•The Bank’s targeted investment profile on its net
equity position.
Non-rate sensitive assets, liabilities and shareholders’equity
are modeled on a consistent basis, assuming an intermediate
term using a rolling 60 month maturity profile resulting in a two
and a half year average duration. Significant assumptions includ-
ed in the valuation of fixed cash flows include the liquidation
assumptions on mortgages not due to embedded optionality.
The portfolio management objective within the closed book is
to eliminate cash flow mismatches thereby preserving the present
value of product margins.
The graph below shows our interest rate risk exposure on
October 31, 2003 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, 2003, the economic value of shareholders’ equity
would have decreased by $13 million after-tax as compared with
$6 million in 2002 for a 100 basis point decrease in rates. This
same shock would reduce net income after-tax by $14 million
over the next 12 months as compared with $2 million in 2002.
Our EVaR in the closed book ranged from $1 to $32 million
during the year ended October 31, 2003.
ASSET LIABILITY MANAGEMENT
Asset liability management deals with managing the market
risks of our traditional banking activities. Market risks
primarily include interest rate risk and foreign exchange risk.
Who is responsible for asset liability management
The Treasury and Balance Sheet Management department within
Finance measures and manages the market risks of our non-trading
banking activities. The Asset/Liability Committee, which is chaired
by the EVP and CFO and includes other senior executives, oversees
and directs Treasury and Balance Sheet Management. The Risk
Committee of the Board reviews and approves all asset liability
management market risk policies periodically.
How we manage our asset and liability positions
We measure all product risks when products are issued, using
a fully-hedged option-adjusted transfer pricing framework. This
framework allows Treasury and Balance Sheet Management
to measure and manage risk within a target risk profile. It also
ensures that the Bank’s business units engage in risk-taking
activities only if they are productive.
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.
The objective of interest rate risk management is to ensure stable
and predictable earnings are realized over time. In this context,
the Bank has adopted a “fully-hedged” approach to profitability
management of its asset and liability positions. Key aspects of
this approach are:
•Negating the impact of interest rate risk on net interest
income and economic value;
•Measuring the contribution of each product on a risk-adjusted,
fully-hedged basis, including the impact of financial options
granted to customers; and
•Developing and implementing strategies to stabilize Personal
and Commercial Banking’s net interest income from all products.
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.
Interest rate risk is measured using interest rate shock scenar-
ios to estimate the impact of changes in interest rates on both
the Bank’s annual Earnings at Risk (EaR) and Economic Value at
Risk (EVaR). EaR is defined as the change in the Bank’s annual
net interest income for a 100 basis point unfavourable interest
rate shock due to mismatched cash flows. EVaR is defined as the
combined difference in the present value of the Bank’s asset
portfolio and the change in the present value of the Bank’s
liability portfolio, including off-balance sheet instruments, for
a 100 basis point unfavorable interest rate shock.
TD BANK FINANCIAL GROUP ANNUAL REPORT 2003 • Management’s Discussion and Analysis
38
Closed (non-optioned) instruments portfolio
economic value at risk by interest rate shock
(millions of dollars as of October 31, 2003)
200-200 -100 0 100
$30
-30
20
10
0
-10
-20
Changes in present value after-tax
Parallel interest rate shock (basis points)