JP Morgan Chase 2005 Annual Report Download - page 80

Management’s discussion and analysis
JPMorgan Chase & Co.
78 JPMorgan Chase & Co. /2005 Annual Report
Immediate changes in interest rates present a limited view of risk, and so a
number of alternative scenarios also are reviewed. These scenarios include the
implied forward curve, nonparallel rate shifts and severe interest rate shocks
on selected key rates. These scenarios are intended to provide a comprehensive
view of JPMorgan Chase’s earnings-at-risk over a wide range of outcomes.
JPMorgan Chase’s 12-month pre-tax earnings sensitivity profile as of
December 31, 2005 and 2004, follows:
Immediate change in rates
(in millions) +200bp +100bp -100bp
December 31, 2005 $ 265 $ 172 $ (162)
December 31, 2004 (557) (164) (180)
The Firm’s risk to rising and falling interest rates is due primarily to correspon-
ding increases and decreases in short-term funding costs.
RIFLE
Individuals who manage risk positions, particularly those that are complex,
are responsible for identifying potential losses that could arise from specific
unusual events, such as a potential tax change, and estimating the probabilities
of losses arising from such events. This information is entered into the Firm’s
RIFLE system and directed to the appropriate level of management, thereby
permitting the Firm to identify further earnings vulnerability not adequately
covered by standard risk measures.
Risk monitoring and control
Limits
Market risk is controlled primarily through a series of limits. Limits reflect the
Firm’s risk appetite in the context of the market environment and business
strategy. In setting limits, the Firm takes into consideration factors such as
market volatility, product liquidity, business track record and management
experience.
MRM regularly reviews and updates risk limits, and senior management
reviews and approves risk limits at least once a year. MRM further controls
the Firm’s exposure by specifically designating approved financial instruments
and tenors, known as instrument authorities, for each business segment.
The Firm maintains different levels of limits. Corporate-level limits include
VAR, stress and loss advisories. Similarly, line of business limits include VAR,
stress and loss advisories, and are supplemented by nonstatistical measure-
ments and instrument authorities. Businesses are responsible for adhering to
established limits, against which exposures are monitored and reported. Limit
breaches are reported in a timely manner to senior management, and the
affected business segment is required to take appropriate action to reduce
trading positions. If the business cannot do this within an acceptable timeframe,
senior management is consulted on the appropriate action.
Qualitative review
MRM also performs periodic reviews as necessary of both businesses and
products with exposure to market risk in order to assess the ability of the
businesses to control their market risk. Strategies, market conditions, product
details and risk controls are reviewed, and specific recommendations for
improvements are made to management.
Model review
Some of the Firm’s financial instruments cannot be valued based upon quoted
market prices but are instead valued using pricing models. Such models are
used for management of risk positions, such as reporting against limits, as well
as for valuation. The Model Risk Group, independent of the businesses and
MRM, reviews the models the Firm uses and assesses model appropriateness
and consistency. The model reviews consider a number of factors about the
model’s suitability for valuation and risk management of a particular product,
including whether it accurately reflects the characteristics of the transaction
and its significant risks, the suitability and convergence properties of numerical
algorithms, reliability of data sources, consistency of the treatment with models
for similar products, and sensitivity to input parameters and assumptions that
cannot be priced from the market.
Reviews are conducted for new or changed models, as well as previously
accepted models, to assess whether there have been any changes in the
product or market that may impact the model’s validity and whether there
are theoretical or competitive developments that may require reassessment
of the model’s adequacy. For a summary of valuations based upon models,
see Critical Accounting Estimates used by the Firm on pages 81–83 of this
Annual Report.
Risk reporting
Nonstatistical exposures, value-at-risk, loss advisories and limit excesses are
reported daily for each trading and nontrading business. Market risk exposure
trends, value-at-risk trends, profit and loss changes, and portfolio concentra-
tions are reported weekly. Stress test results are reported monthly to business
and senior management.