JP Morgan Chase 2008 Annual Report Download - page 114

Management’s discussion and analysis
112 JPMorgan Chase & Co./ 2008 Annual Report
Trading risk
The Firm makes markets and trades its products across several differ-
ent asset classes. These asset classes include primarily fixed income
(which includes interest rate risk and credit spread risk), foreign
exchange, equities and commodities. Trading risk arises from posi-
tions in these asset classes and may lead to the potential decline in
net income (i.e., economic sensitivity) due to adverse changes in
market rates, whether arising from client activities or proprietary
positions taken by the Firm.
Nontrading risk
Nontrading risk arises from execution of the Firm’s core business
strategies, the delivery of products and services to its customers, and
the positions the Firm undertakes to risk-manage its exposures.
These exposures can result from a variety of factors, including differ-
ences in the timing among the maturity or repricing of assets, liabili-
ties and off-balance sheet instruments. Changes in the level and
shape of market interest rate curves also may create interest rate
risk, since the repricing characteristics of the Firm’s assets do not
necessarily match those of its liabilities. The Firm is also exposed to
basis risk, which is the difference in the repricing characteristics of
two floating-rate indices, such as the prime rate and 3-month LIBOR.
In addition, some of the Firm’s products have embedded optionality
that impact pricing and balances.
The Firm’s mortgage banking activities give rise to complex interest
rate risks, as well as option and basis risk. Option risk arises primarily
from prepayment options embedded in mortgages and changes in
the probability of newly originated mortgage commitments actually
closing. Basis risk results from different relative movements between
mortgage rates and other interest rates.
Risk measurement
Tools used to measure risk
Because no single measure can reflect all aspects of market risk, the
Firm uses various metrics, both statistical and nonstatistical, including:
• Nonstatistical risk measures
• Value-at-risk (“VaR”)
• Loss advisories
• Drawdowns
• Economic value stress testing
• Earnings-at-risk stress testing
• Risk identification for large exposures (“RIFLE”)
Nonstatistical risk measures
Nonstatistical risk measures other than stress testing include net
open positions, basis point values, option sensitivities, market values,
position concentrations and position turnover. These measures pro-
vide granular information on the Firm’s market risk exposure. They
are aggregated by line of business and by risk type, and are used for
monitoring limits, one-off approvals and tactical control.
Value-at-risk (“VaR”)
JPMorgan Chase’s primary statistical risk measure,VaR, estimates the
potential loss from adverse market moves in an ordinary market envi-
ronment and provides a consistent cross-business measure of risk
profiles and levels of diversification. VaR is used for comparing risks
across businesses, monitoring limits, and as an input to economic cap-
ital calculations. VaR provides risk transparency in a normal trading
environment. Each business day the Firm undertakes a comprehensive
VaR calculation that includes both its trading and its nontrading risks.
VaR for nontrading risk measures the amount of potential change in
the fair values of the exposures related to these risks; however, for
such risks, VaR is not a measure of reported revenue since nontrading
activities are generally not marked to market through net income.
Hedges of nontrading activities may be included in trading VaR since
they are marked to market.
To calculate VaR, the Firm uses historical simulation, based on a one-
day time horizon and an expected tail-loss methodology, which
measures risk across instruments and portfolios in a consistent and
comparable way. The simulation is based upon data for the previous
12 months. This approach assumes that historical changes in market
values are representative of future changes; this is an assumption
that may not always be accurate, particularly given the volatility in
the current market environment. For certain products, an actual price
time series is not available. In such cases, the historical simulation is
done using a proxy time series to estimate the risk. It is likely that
using an actual price time series for these products, if available,
would impact the VaR results presented. In addition, certain risk
parameters, such as correlation risk among certain IB trading instru-
ments, are not fully captured in VaR.
In the third quarter of 2008, the Firm revised its VaR measurement to
include additional risk positions previously excluded from VaR, thus
creating, in the Firm’s view, a more comprehensive view of its market
risks. In addition, the Firm moved to calculating VaR using a 95%
confidence level to provide a more stable measure of the VaR for
day-to-day risk management. The following sections describe
JPMorgan Chase’s VaR measures under both the legacy 99% confi-
dence level as well as the new 95% confidence level. The Firm
intends to solely present the VaR at the 95% confidence level once
information for two complete year-to-date periods is available.