TD Bank 2009 Annual Report Download - page 111

TD BANK FINANCIAL GROUP ANNUAL REPORT 2009 FINANCIAL RESULTS 107
Interest rate swaps are OTC 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 counterparty 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 series of future dates 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 OTC 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
The Bank uses foreign exchange derivatives, such as futures, forwards
and swaps in managing foreign exchange risks. 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. The Bank is exposed to non-
trading foreign exchange risk from its investments in foreign operations
when the Bank’s foreign currency assets are greater or less than the
liabilities in that currency, they create a foreign currency open position.
Foreign exchange forwards are OTC contracts in which one counter-
party 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 transactions 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 a period 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 transacted on an exchange.
Credit Derivatives
The Bank uses credit derivatives such as CDS and total return swaps in
managing risks of the Bank’s corporate loan portfolio and other cash
instruments. Credit risk is the risk of loss if a borrower or counterparty
in a transaction fails to meet its agreed payment obligations. The
Bank uses credit derivatives to mitigate industry concentration and
borrower-specific exposure as part of the Bank’s portfolio risk manage-
ment
techniques. The credit, legal, and other risks associated with
these transactions are controlled through well established procedures.
The Bank’s policy is to enter into these transactions with investment
grade financial institutions. Credit risk to these counterparties is
managed through the same approval, limit and monitoring processes
that is used for all counterparties to which the Bank has credit exposure.
Credit derivatives are OTC contracts designed to transfer the credit
risk in an underlying financial instrument (usually termed as a reference
asset) from one counterparty to another. The most common credit
derivatives are CDS (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
are made regardless of whether there is a credit event.
Other Derivatives
The Bank also transacts equity and commodity derivatives in both the
exchange and OTC markets.
Equity swaps are OTC contracts in which one counterparty agrees
to pay, or receive from the other, cash amounts based on changes in
the value of a stock index, a basket of stocks or a single stock. These
contracts sometimes include a payment in respect of dividends.
Equity options give the purchaser of the option, for a premium,
the right, but not the obligation, to buy from or sell to the writer
of an option, an underlying stock index, basket of stocks or single
stock at a contracted price. Options are transacted both OTC and
through exchanges.
Equity index futures are standardized contracts transacted on an
exchange. They are based on an agreement to pay or receive a cash
amount based on the difference between the contracted price level
of an underlying stock index and its corresponding market price level
at a specified future date. There is no actual delivery of stocks that
comprise the underlying index. These contracts are in standard amounts
with standard settlement dates.
Commodity contracts include commodity forward, futures, swaps
and options, such as precious metals and energy-related products in
both OTC and exchange markets.
The Bank issues certain loan commitments to customers in Canada
at a fixed price. These funding commitments are accounted for as
derivatives if there is past practice of selling the loans shortly after
funding. These loan commitments are carried at fair value with the
resulting realized and unrealized gains or losses recognized immedi-
ately in other income.
NOTIONAL AMOUNTS
The notional amounts are not recorded as assets or liabilities as they
represent the face amount of the contract to which a rate or price
is applied to determine the amount of cash flows to be exchanged.
Notional principal amounts do not represent the potential gain or
loss associated with market risk and are not indicative of the credit
risk associated with derivative financial instruments.
EMBEDDED DERIVATIVES
Derivatives may be embedded in other financial instruments (the host
instrument). Embedded derivatives are treated as separate derivatives
when their economic characteristics and risks are not clearly and
closely related to those of the host instrument, a separate instrument
with the same terms as the embedded derivative would meet the
definition of a derivative, and the combined contract is not held for
trading or designated as trading under the fair value option. These
embedded derivatives are measured at fair value with subsequent
changes recognized in trading income.
Certain of the Bank’s deposit obligations that vary according to
the performance of certain equity levels or indices may be subject to
a guaranteed minimum redemption amount and have an embedded
derivative. The Bank accounts for the embedded derivative of such
variable obligations at fair value with changes in fair value reflected
in other income as they arise. The Bank does not expect significant
future earnings volatility as the embedded derivatives are effectively
hedged. The fair value of the embedded derivatives are recorded on
the Consolidated Balance Sheet as derivatives.