TD Bank 2005 Annual Report Download - page 66

TD BANK FINANCIAL GROUP ANNUAL REPORT 2005 Management’s Discussion and Analysis
62
The objective of portfolio management within the closed book
is to eliminate cash flow mismatches, thereby reducing the
volatility of net interest income.
The graph below shows our interest rate exposure on October
31, 2005 on the closed (non-optioned) instruments within the
financial position. If this portfolio had experienced an immediate
and sustained 100 basis point increase in rates on October 31,
2005, the economic value of shareholders’ equity would have
decreased by $26 million after tax, compared with $110 million
for a 100 basis point increase in rates on October 31, 2004. A
100 basis point decrease in rates would reduce net income by
$15 million over the next 12 months, compared with $11 million
for a 100 basis point decrease in rates in 2004.2
Product options, whether they are freestanding options such
as mortgage rate commitments or embedded in loans and
deposits, expose the Bank to a significant financial risk.
Our exposurefrom freestanding mortgage rate commitment
options is modelled based on an expected funding ratio derived
from historical experience. We model our exposure to written
options imbedded in other products, such as the rights to prepay
or redeem, based on analysis of rational customer behaviour.
Wealso 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
purchasing options or through a dynamic hedging process
designed to replicate the payoff on a purchased option.
The following graph shows our interest rate risk exposureon
October 31, 2005 on all instruments within the financial position
(i.e., the closed (non-optioned) instruments plus product
options). An immediate and sustained 100 basis points increase
in rates would have decreased the economic value of sharehold-
ers’ equity by $36 million after tax or 0.23% of common equity,
compared with $124 million in 2004 for a 100 basis point
increase in rates. Our EVaR for the total portfolio ranged from
$35 to $118 million during the year ended October 31, 2005.3
The Bank’spolicy sets overall limits on EVaR and EaR based on a
100 basis point interest rate shock.
Managing Non-Trading 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.
Weare exposed to non-trading foreign exchange risk from
our investments in foreign operations, and when our foreign
currency assets are greater or less than our liabilities in that
currency, creating a foreign currency open position. An adverse
change in foreign exchange rates can impact the Bank’s reported
net income and equity,and also the Bank’s capital ratios. Our
objective is to minimize these impacts.
Minimizing the impact of an adverse foreign exchange rate
change on reported equity will cause some variability in capital
ratios, due to the amount of risk-weighted assets that are
denominated in a foreign currency. If the Canadian dollar weak-
ens, the Canadian-dollar equivalent of the Bank’s risk-weighted
assets in a foreign currency increases, thereby increasing the
Bank’s capital requirement. For this reason, the foreign exchange
risk arising from the Bank’s net investment in foreign operations
is hedged to the point wherecapital 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.
WHY PRODUCT MARGINS FLUCTUATE OVER TIME
As explained above, a fully hedged approach to asset liability
management locks in margins on fixed rate loans and deposits,
as they are booked. It also mitigates the impact of an instanta-
neous interest-rate shock on the level of net interest income to
be earned over time as a result of cash flow mismatches and the
exercise of embedded options. Despite a fully hedged position,
however,the margin on average earning assets can change over
time for the following reasons:
•Margins earned on new and renewing fixed-rate products
relative to the margin previously earned on matured products
will impact on the existing portfolio margin.
•The weighted average margin on average earning assets will
shift due to changes in the mix of business.
•Changes in the prime-Bankers’ Acceptances basis and the lag
in changing product prices in response to changes in wholesale
rates may have an impact on margins earned.
•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.
Closed (non-optioned) instruments portfolio
Economic Value at Risk After Tax – Oct. 31, 2005
(millions of Canadian dollars)
-20
-10
5
$10
-15
-5
0
Rate shift %
Change in present value
-2.0 -1.0-1.5 -0.5 0 0.5 1.0 1.5 2.0
All instruments portfolio
Economic Value at Risk After Tax – oct. 31, 2005
(millions of Canadian dollars)
-100
-40
-20
-60
-80
$20
0
Rate shift %
Change in present value
-2.0 -1.5 -1 -0.5 0 0.5 1.0 1.5 2.0
2, 3 EVAR and EAR information excludes the impact of TD Banknorth exposures.