TD Bank 2009 Annual Report Download - page 110

TD BANK FINANCIAL GROUP ANNUAL REPORT 2009 FINANCIAL RESULTS106
DERIVATIVE FINANCIAL INSTRUMENTS
NOTE 8
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 for trading purposes and non-trading purposes to manage
the risks associated with its funding and investing strategies.
DERIVATIVES HELD FOR TRADING PURPOSES
The Bank enters into trading derivative contracts to meet the needs of
its customers, to enter into trading positions, and in certain cases, to
manage risks related to its trading portfolio. Trading derivatives are
recorded at fair value with the resulting realized and unrealized gains
or losses recognized immediately in trading income.
DERIVATIVES HELD FOR NON-TRADING
When derivatives are held for non-trading purposes and when the
transactions meet the requirements of Section 3865, Hedges, they are
classified by the Bank as non-trading derivatives and receive hedge
accounting treatment, as appropriate. Certain derivative instruments
that are held for economic hedging purposes, and do not meet the
requirements of Section 3865, are also classified as non-trading deriva-
tives but the change in fair value of these derivatives is recognized in
other income.
HEDGING RELATIONSHIPS
Hedge Accounting
At the inception of a hedging relationship, the Bank documents the
relationship between the hedging instrument and the hedged item, its
risk management objective and its strategy for undertaking the hedge.
The Bank also requires a documented assessment, both at hedge
inception and on an ongoing basis, of whether or not the derivatives
that are used in hedging transactions are highly effective in offsetting
the changes attributable to the hedged risks in the fair values or cash
flows of the hedged items. In order to be deemed effective, the hedging
instrument and the hedged item must be highly and inversely corre-
lated such that the changes in the fair value of the hedging instrument
will substantially offset the effects of the hedged exposure to the Bank
throughout the term of the hedging relationship. If a hedging relation-
ship 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, without any mitigating impact in earnings,
where appropriate.
The gain or loss relating to the derivative component excluded from
the assessment of hedge effectiveness is recognized immediately in the
Consolidated Statement of Income.
When derivatives are designated as hedges, the Bank classifies them
either as: i) hedges of the change in fair value of recognized assets
or liabilities or firm commitments (fair value hedges); ii) hedges of
the variability in highly probable future cash flows attributable to a
recog
nized asset or liability, or a forecasted transaction (cash flow
hedges); or iii) hedges of net investments in a foreign operation
(net investment hedges).
Fair Value Hedges
The Bank’s fair value hedges principally consist of interest rate swaps
that are used to protect against changes in the fair value of fixed-
rate long-term financial instruments due to movements in market
interest rates.
Changes in the fair value of derivatives that are designated and
qualify as fair value hedging instruments are recorded in the Consoli-
dated Statement of Income, along with changes in the fair value
of the assets, liabilities or group thereof that are attributable to the
hedged risk. Any gain or loss in fair value relating to the ineffective
portion of the hedging relationship is recognized immediately in the
Consolidated Statement of Income in other income.
The cumulative adjustment to the carrying amount of the hedged
item (the basis adjustment) is amortized to the Consolidated State-
ment of Income based on a recalculated effective interest rate over
the remaining expected life of the hedged item, with amortization
beginning no later than when the hedged item ceases to be adjusted
for changes in its fair value attributable to the hedged risk. Where
the hedged item has been derecognized, the basis adjustment
is immediately released to the Consolidated Statement of Income.
Cash Flow Hedges
The Bank is exposed to variability in future cash flows that are denomi-
nated in foreign currencies, as well as variability in future cash flows
on non-trading assets and liabilities that bear interest at variable
rates, or are expected to be refunded or reinvested in the future. The
amounts and timing of future cash flows are projected for each
hedged exposure on the basis of their contractual terms and other
relevant factors, including estimates of prepayments and defaults. The
aggregate cash flows across all hedged exposures over time form the
basis for identifying the effective portion of gains and losses on the
derivatives designated as cash flow hedges of forecasted transactions.
The effective portion of changes in the fair value of derivatives that
are designated and qualify as cash flow hedges is recognized in other
comprehensive income. Any gain or loss in fair value relating to the
ineffective portion is recognized immediately in the Consolidated
Statement of Income in other income.
Amounts accumulated in other comprehensive income are reclassi-
fied to the Consolidated Statement of Income in the period in which
the hedged item affects income.
When a hedging instrument expires or is sold, or when a hedge no
longer meets the criteria for hedge accounting, any cumulative gain or
loss existing in other comprehensive income at that time remains in
other comprehensive income until the forecasted transaction is eventu-
ally recognized in the Consolidated Statement of Income. When a
forecasted transaction is no longer expected to occur, the cumulative
gain or loss that was reported in other comprehensive income is
immediately transferred to the Consolidated Statement of Income.
Net Investment Hedges
Hedges of net investments in foreign operations are accounted for
similar to cash flow hedges. Any gain or loss on the hedging instrument
relating to the effective portion of the hedge is recognized in other
comprehensive income. The gain or loss relating to the ineffective
portion is recognized immediately in the Consolidated Statement of
Income. Gains and losses accumulated in other comprehensive income
are included in the Consolidated Statement of Income upon the repa-
triation or disposal of the investment in the foreign operation.
DERIVATIVE PRODUCT TYPES AND RISK EXPOSURES
The majority of the Bank’s derivative contracts are over-the-counter
(OTC) 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
The Bank uses interest rate derivatives, such as interest rate futures
and forwards, swaps, and options in managing interest rate risks.
Interest rate risk is the impact that changes in interest rates could
have on the Bank’s margins, earnings, and economic value. Changes
in interest rate can impact the market value of fixed rate assets
and liabilities. Further, certain assets and liabilities repayment rates
vary depending on interest rates.
Forward rate agreements are OTC contracts that effectively fix a
future interest rate for a period of time. A typical forward rate agree-
ment provides that at a pre-determined future date, a cash settlement
will be made between the counterparties based upon the difference
between a contracted rate and a market rate to be determined in the
future, calculated on a specified notional principal amount. No
exchange of principal amount takes place.