NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 21 Risk Management NOTE 22 Contingent Liabilities (a) Legal Proceedings (b) Pledged Assets NOTE 23 Derivative Financial Instruments Asset/Liability Management (GLYPH<210>ALMGLYPH<211>) Derivatives Customer Trading Derivatives Hedging Derivatives  86 BMO FINANCIAL GROUP ANNUAL REPORT 2002 Customer trading derivatives are marked to market. Realized and unrealized gains and losses are recorded in trading revenues. A portion of the income derived  from marking derivatives to market in respect of credit, model and liquidity risks as well as administrative costs is deferred and amortized to trading revenues, as appropriate. Unrealized gains on trading derivatives are recorded in other assets and unrealized losses are recorded in other liabilities. Cross-currency swaps and equity derivatives are marked to market with realized and unrealized gains and losses recorded in non-interest revenue, along with the gains and losses of the items hedged. Credit derivatives entered into for hedging purposes are accounted for as off-balance sheet financial guarantees. Swaps and options that qualify as hedges are accounted for on the accrual basis. For interest rate swaps, interest income received and interest expense paid on the derivative is accrued as an adjustment to the yield of the item being hedged over the term of the hedge contract. For purchased options, premiums are amortized to interest expense over the term of the contract. Accrued interest receivable and payable and deferred gains and losses for these contracts are r ecorded in other assets or liabilities as appropriate. Realized gains and losses from the settlement or the early termination of hedge contracts are deferred and amortized over the remaining original life of the hedged item.  We conduct our customer trading activities through business units dealing in both on- and off-balance sheet positions, including derivatives, which are marked to market. The revenue generated by these units is set out on page 21 of our Management’s Discussion and Analysis. Customer trading derivative transactions are comprised of sales and other activities. Sales activities include the structuring and  marketing of derivative products to customers to enable them to transfer, modify or reduce current or expected risks. Other activi- ties include market-making, positioning and arbitrage activities. Market-making activities involve quoting bid and offer prices to other market participants with the intention of generating revenues based on spread and volume. Positioning activities involve managing market risk positions with the expectation of profiting from favour- able movements in prices, rates or indices. Arbitrage activities involve identifying and profiting from price differentials between markets and products. We may also take proprietary trading posi- tions in various capital markets instruments and derivatives, which are designed to profit from anticipated changes in market factors. derivative will qualify as a hedge if the hedge relationship is designated and formally documented at inception, detailing the particular risk management objective and strategy for the hedge, the specific asset, liability or cash flow being hedged, as well as how effectiveness is being assessed. In addition, changes  in the fair value of the derivative must be highly effective in offsetting either changes in the fair value of on-balance sheet items or changes in the amount of future cash flows. The effectiveness of these hedging relationships is evaluated at inception of the hedge and on an ongoing basis, both retrospectively and prospectively using quantitative statistical measures of correlation. If a hedge r elationship is found to be ineffective, the derivative is redesignated as customer trading. Subsequent changes in the fair value of derivatives originally identified as hedges, but which are no longer effective as hedges, are redesignated as customer trading and are reported in trading revenues. In accordance with our risk management strategy, we enter into  various derivative instruments to hedge our interest rate, foreign currency and equity exposures.  We enter into interest rate, foreign exchange, commodity, equity and credit contracts to enable our customers to manage risk, and for asset/liability management purposes where we manage the risk associated with our balance sheet positions. The Bank and its subsidiaries are party to other legal proceedings in the ordinary course of their businesses. Management does not expect the outcome of any of these other proceedings, individually or in the aggregate, to have a material adverse effect on the consoli- dated financial position or results of the Bank’s operations. BMO Nesbitt Burns Inc., an indirect subsidiary of Bank of Montreal, has been named as a defendant in several class and individual actions in Canada and a class action in the United States brought on behalf of shareholders of Bre-X Minerals Ltd. (“Bre-X”). Other defendants named in one or more of these actions include Bre-X, officers and directors of Bre-X, a mining consulting firm retained by Bre-X, Bre-X’s financial advisor, brokerage firms which sold Bre-X common stock, and a major gold production company. These actions are largely based on allegations of negligence, negligent or fraudulent misrepresentation and a breach of the  U.S. Securities Exchange Act of 1934 (United States only), in connection with the sale of Bre-X securities. Two of the proposed class actions in Canada have been dismissed as to BMO Nesbitt Burns Inc. All of the other actions are at a preliminary stage. Based upon information presently available, counsel for BMO Nesbitt Burns Inc. is not in a position to express an opinion as to the likely outcome of any of these actions. Management is of the view that BMO Nesbitt Burns Inc. has strong defences and will vigorously defend against all such actions. In the normal course of our business, we pledge assets as security for various liabilities that we incur. We had pledged investment  and trading securities and other assets totalling $35,214 as at October 31, 2002 and $31,388 as at October 31, 2001 as security  for call loans, securities sold but not yet purchased, securities  sold under repurchase agreements and other secured liabilities. Additionally, we had deposited assets in the amount of $2,204 as at October 31, 2002 and $1,846 as at October 31, 2001 to act as security for our participation in clearing and payment systems and as secu- rity for contract settlements with derivatives exchanges or other derivative counterparties. The following table summarizes our assets pledged: consolidated financial statements. A summary of our interest rate gap position and effective interest rates on our financial instrument assets and liabilities is set out on page 62 of our Management’s Discussion and Analysis. Our business necessitates the management of several categories  of risk including credit, market, liquidity and operational risks. Certain information about our exposure to these risks such as the allowance for credit losses, trading revenue, derivative financial instruments and fair value of financial instruments are set out in our Excludes restricted cash resources disclosed in Note 2. 2002 2001 C ash resources $ 78 $ 260 Sec urities Issued or guaranteed by Canada  5,606 3,659 Issued or guaranteed by a Canadian province, municipality or school corporation  886 923 Other securities  12,032 10,792 Ot her assets  18,816 17,600 Total assets pledged  $ 37,418 $ 33,234