TD Bank 2011 Annual Report Download - page 114

TD BANK GROUP ANNUAL REPORT 2011 FINANCIAL RESULTS112
gain or loss that was reported in other comprehensive income is imme-
diately 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 change in fair value on the hedging
instrument relating to the effective portion of the hedge is recognized
in other comprehensive income. The change in fair value relating to
the ineffective portion is recognized immediately in the Consolidated
Statement of Income. Gains and losses accumulated in other com -
prehensive income are included in the Consolidated Statement of
Income upon the repatriation or disposal of the investment in the
foreign operation.
DERIVATIVE PRODUCT TYPES AND RISK EXPOSURES
The majority of the Bank’s derivative contracts are 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.
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 cash 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 credit default swaps (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 management 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 or group of assets
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 forwards, 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 rate. These funding commitments are accounted for as deriv-
atives 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 immediately in
other income.