TD Bank 2003 Annual Report Download - page 41

TD BANK FINANCIAL GROUP ANNUAL REPORT 2003 • Management’s Discussion and Analysis 39
Product options, which expose the Bank to a non-linear or
asymmetrical payoff profile, represent a significant financial risk,
whether they are freestanding, such as mortgage rate commit-
ments or embedded in loans and deposits. Freestanding mortgage
rate commitment options are modeled based on an expected
funding ratio derived from historical experience. The written
option exposures contained in products with embedded options
to early prepay or redeem are modeled based on an assumed
percentage rational exercise derived from customer behaviour
analysis. Economic capital is held to guard against worst case
losses in the event rational exercise assumptions are exceeded.
We also model an exposure to declining interest rates resulting
in margin compression on certain interest rate sensitive demand
deposit accounts. Product option exposures are managed by pur-
chasing 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 following graph shows our interest rate risk exposure on
October 31, 2003 on all instruments within the financial position
–the closed (non-optioned) instruments plus product options.
The modeled exposures described above define the Bank’s risk
neutral position. The only residual exposure arises from dynamic
hedging. The following graph assumes that the dynamic hedging
portfolios held on October 31 are not rebalanced for the interest
rate shock. An immediate and sustained 100 basis point decrease
in rates would have decreased the economic value of shareholders’
equity by $30 million after-tax or .3% of common equity as com-
pared with $46 million in 2002. Our EVaR for the total portfolio
ranged from $23 million to $66 million during the year ended
October 31, 2003. The Bank’s policy sets overall limits on EVaR
and EaR. EVaR arising from mismatched asset liability positions
cannot exceed 3% of the Bank’s common equity or $347 million.
EaR exposure may not exceed 3% of the Bank’s annualized net
interest income or $175 million.
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, creating a foreign currency open
position; or
•From our investments in foreign operations.
Our objective is to minimize the impact of an adverse foreign
exchange rate change on reported net income and equity, and to
minimize the impact of an adverse foreign exchange rate change
on the Bank’s capital ratios. Minimizing the impact of an adverse
foreign exchange rate change on reported equity will cause some
variability in the capital ratios due to the amount of risk-weighted
assets that are denominated in a foreign currency. In the event
that the Canadian dollar weakens, the Canadian dollar equivalent
of the Bank’s risk-weighted assets in a foreign currency increases
thereby increasing the Bank’s capital requirement. As a result, the
foreign exchange risk arising from the Bank’s net investment in
foreign operations is hedged up to the point where the capital
ratios change by no more than a tolerable amount for a given
change in foreign exchange rates. The tolerable amount increases
as the Bank’s capital ratio increases.
The Bank’s policy related to open currency exposure is to limit
exposure to no more than $200 million in aggregate. Our policy
related to foreign exchange capital exposure is to minimize an
adverse foreign exchange rate change on reported equity subject
to the constraint that the Bank’s capital ratios can change by no
more than 10 basis points for a 5% change in foreign exchange
rates. If target capital ratios are exceeded, the Bank’s policy
is to allow for a 25 basis point change in capital ratios for a 5%
change in foreign exchange rates.
Why product margins fluctuate over time
Implementing a fully-hedged approach to asset liability manage-
ment locks in margins on fixed rate loans and deposits as they
are booked. The process mitigates the impact of an instantaneous
interest rate shock on the level of net interest income to be earned
over time due to cash flow mismatches and the exercise of
embedded options. Despite a fully-hedged position, the margin
on average earning assets is subject to change over time due to
the following:
•Margins earned on new and renewing fixed rate products
relative to the margin previously earned on matured products
will impact the existing portfolio margin;
•The weighted average margin on average earning assets will
shift due to changes in the mix of business;
•The risk of changes in the prime-BA basis and the lag in
changing product pricing may have an impact on margins
earned; and
•The general level of interest rates will impact the return the
Bank generates on its modeled maturity profile for core
deposits and the investment profile for its net equity position
as it evolves over time. The general level of interest rates is
also a key driver of some modeled option exposures, and will
affect the cost of hedging such exposures.
By implementing a fully-hedged approach, the impact of these
contributions to changing margins is muted over time resulting in
a more stable and predictable earnings stream.
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 arise from withdrawals of deposits, debt maturities
and commitments to provide credit. Liquidity risk also
includes the risk of not being able to liquidate assets in a
timely manner at a reasonable price.
It is the Bank’s policy to ensure that there is adequate liquidity
coverage across all business units to sustain our ongoing opera-
tions in the event of a funding disruption with limited reliance on
the forced sale of assets. We also ensure that there is sufficient
liquidity available to fund asset growth and strategic opportunities.
Total financial position
economic value at risk by interest rate shock
(millions of dollars as of October 31, 2003)
200-200 -100 0 100
$20
-100
0
-20
-40
-60
-80
Changes in present value after-tax
Parallel interest rate shock (basis points)