JP Morgan Chase 2006 Annual Report Download - page 137

JPMorgan Chase & Co. / 2006 Annual Report 135
Note 31 – Fair value of financial instruments
The fair value of a financial instrument is the amount at which the instrument
could be exchanged in a current transaction between willing parties, other
than in a forced or liquidation sale.
The accounting for an asset or liability may differ based upon the type of
instrument and/or its use in a trading or investing strategy. Generally, the
measurement framework in the consolidated financial statements is one of
the following:
• at fair value on the Consolidated balance sheets, with changes in fair value
recorded each period in the Consolidated statements of income;
• at fair value on the Consolidated balance sheets, with changes in fair value
recorded each period in the Accumulated other comprehensive income
component of Stockholders’ equity and as part of Other comprehensive
income;
• at cost (less other-than-temporary impairments), with changes in fair value
not recorded in the consolidated financial statements but disclosed in the
notes thereto; or
• at the lower of cost or fair value.
Determination of fair value
The Firm has an established and well-documented process for determining
fair values. Fair value is based upon quoted market prices, where available.
If listed prices or quotes are not available, fair value is based upon internally
developed models that primarily use market-based or independent information
as inputs to the valuation model. Valuation adjustments may be necessary to
ensure that financial instruments are recorded at fair value. These adjustments
include amounts to reflect counterparty credit quality, liquidity and
concentration concerns and are based upon defined methodologies that
are applied consistently over time.
• Credit valuation adjustments are necessary when the market price (or
parameter) is not indicative of the credit quality of the counterparty. As
few derivative contracts are listed on an exchange, the majority of derivative
positions are valued using internally developed models that use as their
basis observable market parameters. Market practice is to quote parameters
equivalent to a AA credit rating; thus, all counterparties are assumed to
have the same credit quality. An adjustment is therefore necessary to
reflect the credit quality of each derivative counterparty and to arrive at
fair value.
• Liquidity adjustments are necessary when the Firm may not be able to
observe a recent market price for a financial instrument that trades in inactive
(or less active) markets. Thus, valuation adjustments for the risk of loss due
to a lack of liquidity are applied to those positions to arrive at fair value.
The Firm tries to ascertain the amount of uncertainty in the initial valuation
based upon the degree of liquidity or illiquidity, as the case may be, of the
market in which the instrument trades and makes liquidity adjustments to
the financial instruments. The Firm measures the liquidity adjustment based
upon the following factors: (1) the amount of time since the last relevant
pricing point; (2) whether there was an actual trade or relevant external
quote; and (3) the volatility of the principal component of the financial
instrument.
• Concentration valuation adjustments are necessary to reflect the cost of
unwinding larger-than-normal market-size risk positions. The cost is deter-
mined based upon the size of the adverse market move that is likely to
occur during the extended period required to bring a position down to a
nonconcentrated level. An estimate of the period needed to reduce, without
market disruption, a position to a nonconcentrated level is generally based
upon the relationship of the position to the average daily trading volume of
that position. Without these adjustments, larger positions would be valued
at a price greater than the price at which the Firm could exit the positions.
Valuation adjustments are determined based upon established policies and are
controlled by a price verification group, which is independent of the risk-taking
function. Economic substantiation of models, prices, market inputs and revenue
through price/input testing, as well as back-testing, is done to validate the appro-
priateness of the valuation methodology. Any changes to the valuation method-
ology are reviewed by management to ensure the changes are justified.
The methods described above may produce a fair value calculation that may
not be indicative of net realizable value or reflective of future fair values.
Furthermore, the use of different methodologies to determine the fair value
of certain financial instruments could result in a different estimate of fair
value at the reporting date.
Certain financial instruments and all nonfinancial instruments are excluded
from the scope of SFAS 107. Accordingly, the fair value disclosures required
by SFAS 107 provide only a partial estimate of the fair value of JPMorgan
Chase. For example, the Firm has developed long-term relationships with its
customers through its deposit base and credit card accounts, commonly
referred to as core deposit intangibles and credit card relationships. In the
opinion of management, these items, in the aggregate, add significant value
to JPMorgan Chase, but their fair value is not disclosed in this Note.
The following items describe the methodologies and assumptions used, by
financial instrument, to determine fair value.
Financial assets
Assets for which fair value approximates carrying value
The Firm considers fair values of certain financial assets carried at cost – including
cash and due from banks, deposits with banks, securities borrowed, short-term
receivables and accrued interest receivable – to approximate their respective car-
rying values, due to their short-term nature and generally negligible credit risk.
Federal funds sold and securities purchased under resale agreements
Federal funds sold and securities purchased under resale agreements are
typically short-term in nature and, as such, for a significant majority of the
Firm’s transactions, cost approximates carrying value. This balance sheet item
also includes structured resale agreements and similar products with long-
dated maturities. To estimate the fair value of these instruments, cash flows
are discounted using the appropriate market rates for the applicable maturity.
Trading debt and equity instruments
The Firm’s debt and equity trading instruments are carried at their estimated
fair value. Quoted market prices, when available, are used to determine the fair
value of trading instruments. If quoted market prices are not available, then
fair values are estimated by using pricing models, quoted prices of instruments
with similar characteristics, or discounted cash flows.
Securities
Fair values of actively traded securities are determined by quoted external
dealer prices, while the fair values for nonactively traded securities are based
upon independent broker quotations.