TD Bank 2006 Annual Report Download - page 103

TD BANK FINANCIAL GROUP ANNUAL REPORT 2006 Financial Results 99
Derivative financial instruments are financial contracts that
derive their value from underlying changes in interest rates,
foreign exchange rates, credit spreads, commodity prices,
equities or other financial measures. Such instruments include
interest rate, foreign exchange, equity, commodity and credit
derivative contracts.
The Bank uses these instruments to manage the risks associated
with its funding and investing strategies or for trading purposes.
DERIVATIVES HELD FOR TRADING PURPOSES
The Bank enters into trading derivative contracts to meet the
needs of its customers and to enter into trading positions, and
in certain cases, to manage risk. Trading derivatives are recorded
at fair value with the resulting realized and unrealized gains or
losses recognized immediately in other income.
DERIVATIVES HELD FOR NON-TRADING PURPOSES
Derivatives used for risk management purposes are generally clas-
sified by the Bank as non-trading derivatives and receive hedge
accounting treatment. Non-trading derivatives are generally
recorded off-balance sheet as hedges with the realized and unre-
alized gains and losses resulting from these contracts recognized
in income on a basis consistent with the hedged on-balance
sheet financial asset or liability or the hedged off-balance sheet
anticipated transaction. Premiums on purchased options are
deferred at inception and amortized into other income over the
contract life.
HEDGING RELATIONSHIPS
To qualify for hedge accounting, the details of the hedging
relationship must be formally documented at inception of the
relationship. The hedge documentation must describe the risk
management objective, identify the nature of the hedging strate-
gy,describe the hedged item, identify the specific risk(s) that are
being hedged, provide adescription of the hedging instrument
and explain how hedge effectiveness is being assessed.
The hedging instrument and the hedged item must be highly
and inversely correlated such that the changes in the fair value of
the hedging instrument will substantially offset the effects of the
hedged exposureto the Bank throughout the term of the hedg-
ing relationship. Effectiveness is evaluated on a prospective and
retrospective basis. If a hedge relationship becomes ineffective,
it no longer qualifies for hedge accounting and any subsequent
change in the fair value of the hedging instrument is recognized
in earnings.
The Bank’s non-trading derivatives that have been designated
in a hedging relationship and meet the effectiveness test, are
considered effective. Ineffective hedging relationships and hedges
not designated in a hedging relationship are carried at fair value
and will result in earnings volatility.
The Bank’scredit default swap portfolio with a notional value
of $3 billion does not qualify for hedge accounting and has been
carried at fair value. The earnings impact of derivatives not
qualifying for hedge accounting was $7 million income after-tax
(2005 – $17 million income after tax).
Hedges of interest rate commitments are also carried at fair
value. The upfront commitment cost, net of payoffs, is deferred
and amortized over the life of the underlying mortgage.
DERIVATIVE PRODUCT TYPES
The majority of the Bank’s derivative contracts are over-the-
counter transactions that are privately negotiated between the
Bank and the counterparty to the contract. The remainder are
exchange-traded contracts transacted through organized and
regulated exchanges and consist primarily of options and futures.
INTEREST RATE DERIVATIVES
Forward rate agreements are over-the-counter contracts that
effectively fix afutureinterest rate for a period of time. A typical
forwardrate agreement provides that at a pre-determined future
date, a cash settlement will be made between the counterparties
based upon the difference between acontracted rate and a mar-
ket rate to be determined in the future, calculated on a specified
notional principal amount. No exchange of principal amount
takes place.
Interest rate swaps are over-the-counter contracts in which
two counterparties agree to exchange cash flows over a period
of time based on rates applied to a specified notional principal
amount. A typical interest rate swap would require one counter-
party to pay a fixed market interest rate in exchange for a
variable market interest rate determined from time to time,
with both calculated on a specified notional principal amount.
No exchange of principal amount takes place.
Interest rate options are contracts in which one party (the
purchaser of an option) acquires from another party (the writer
of an option), in exchange for a premium, the right, but not the
obligation, either to buy or sell, on a specified future date or
within a specified time, a specified financial instrument at a
contracted price. The underlying financial instrument will have a
market price which varies in response to changes in interest rates.
In managing the Bank’s interest rate exposure, the Bank acts
as both a writer and purchaser of these options. Options are
transacted both over-the-counter and through exchanges.
Interest rate futures are standardized contracts transacted on
an exchange. They are based upon an agreement to buy or sell a
specified quantity of a financial instrument on a specified future
date, at a contracted price. These contracts differ from forward
rate agreements in that they are in standard amounts with
standard settlement dates and are transacted on an exchange.
FOREIGN EXCHANGE DERIVATIVES
Foreign exchange forwards are over-the-counter contracts in
which one counterparty contracts with another to exchange a
specified amount of one currency for a specified amount of a
second currency, at a future date or range of dates.
Swap contracts comprise foreign exchange swaps and cross-
currency interest rate swaps. Foreign exchange swaps are transac-
tions in which a foreign currency is simultaneously purchased in
the spot market and sold in the forward market, or vice-versa.
Cross-currency interest rate swaps are transactions in which
counterparties exchange principal and interest flows in different
currencies over aperiod of time. These contracts are used to
manage both currency and interest rate exposures.
Foreign exchange futures contracts are similar to foreign
exchange forward contracts but differ in that they are in standard
currency amounts with standard settlement dates and are trans-
acted on an exchange.
CREDIT DERIVATIVES
Credit derivatives are over-the-counter contracts designed to
transfer the credit risk in an underlying financial instrument (usu-
ally termed as a reference asset) from one counterparty to anoth-
er. The most common credit derivatives are credit default swaps
(referred to as option contracts) and total return swaps (referred
to as swap contracts). In option contracts, an option purchaser
acquires credit protection on a reference asset or group of assets
from an option writer in exchange for a premium. The option
purchaser may pay the agreed premium at inception or over a
period of time. The credit protection compensates the option
purchaser for any deterioration in value of the reference asset
upon the occurrence of certain credit events such as bankruptcy
or failure to pay. Settlement may be cash based or physical,
requiring the delivery of the reference asset to the option writer.
In swap contracts, one counterparty agrees to pay or receive
from the other cash amounts based on changes in the value of a
reference asset or group of assets, including any returns such as
interest earned on these assets in exchange for amounts that are
based on prevailing market funding rates. These cash settlements
aremade regardless of whether there is a credit event.
OTHER DERIVATIVES
The Bank also transacts equity and commodity derivatives in both
the exchange and over-the-counter markets.
Equity swaps areover-the-counter contracts in which one
counterparty agrees to pay, or receive from the other, cash
amounts based on changes in the value of astock index, a basket
of stocks or a single stock. These contracts sometimes include a
payment in respect of dividends.
DERIVATIVE FINANCIAL INSTRUMENTS
NOTE 19