JP Morgan Chase 2009 Annual Report Download - page 178

Notes to consolidated financial statements
JPMorgan Chase & Co./2009 Annual Report 176
these foreign currency–denominated assets or liabilities, or forecasted
transactions, are expected to substantially offset this variability.
Commodities based forward and futures contracts are used to
manage the price risk of certain inventory, including gold and base
metals, in the Firm's commodities portfolio. Gains or losses on the
forwards and futures are expected to substantially offset the depre-
ciation or appreciation of the related inventory. Also in the com-
modities portfolio, electricity and natural gas futures and forwards
contracts are used to manage price risk associated with energy-
related tolling and load-serving contracts and investments.
The Firm uses credit derivatives to manage the counterparty credit
risk associated with loans and lending-related commitments. Credit
derivatives compensate the purchaser when the entity referenced in
the contract experiences a credit event, such as bankruptcy or a
failure to pay an obligation when due. For a further discussion of
credit derivatives, see the discussion in the Credit derivatives sec-
tion on pages 181–183 of this Annual Report.
For more information about risk management derivatives, see the
risk management derivatives gains and losses table on page 180 of
this Annual Report.
Notional amount of derivative contracts
The following table summarizes the notional amount of derivative
contracts outstanding as of December 31, 2009 and 2008.
Notional amounts(c)
December 31, (in billions) 2009 2008
Interest rate contracts
Swaps(a) $ 47,663 $ 54,524
Futures and forwards 6,986 6,277
Written options 4,553 4,803
Purchased options 4,584 4,656
Total interest rate contracts 63,786 70,260
Credit derivatives(b) 5,994 8,388
Foreign exchange contracts
Cross-currency swaps(a) 2,217 1,681
Spot, futures and forwards 3,578 3,744
Written options 685 972
Purchased options 699 959
Total foreign exchange contracts 7,179 7,356
Equity contracts
Swaps 81 77
Futures and forwards 45 56
Written options 502 628
Purchased options 449 652
Total equity contracts 1,077 1,413
Commodity contracts
Swaps 178 234
Spot, futures and forwards 113 115
Written options 201 206
Purchased options 205 198
Total commodity contracts 697 753
Total derivative notional amounts $ 78,733 $
88,170
(a) In 2009, cross-currency interest rate swaps previously reported in interest rate
contracts were reclassified to foreign exchange contracts to be more consis-
tent with industry practice. The effect of this change resulted in a reclassifica-
tion of $1.7 trillion in notional amount of cross-currency swaps from interest
rate contracts to foreign exchange contracts as of December 31, 2008.
(b) Primarily consists of credit default swaps. For more information on volumes and
types of credit derivative contracts, see the Credit derivatives discussion on
pages 181–183 of this Note.
(c) Represents the sum of gross long and gross short third-party notional deriva-
tive contracts.
While the notional amounts disclosed above give an indication of
the volume of the Firm’s derivative activity, the notional amounts
significantly exceed, in the Firm’s view, the possible losses that
could arise from such transactions. For most derivative transactions,
the notional amount does not change hands; it is used simply as a
reference to calculate payments.
Accounting for derivatives
All free-standing derivatives are required to be recorded on the
Consolidated Balance Sheets at fair value. The accounting for
changes in value of a derivative depends on whether or not the
contract has been designated and qualifies for hedge accounting.
Derivatives that are not designated as hedges are marked to mar-
ket through earnings. The tabular disclosures on pages 177–183 of
this Note provide additional information on the amount of, and
reporting for, derivative assets, liabilities, gains and losses. For
further discussion of derivatives embedded in structured notes, see
Notes 3 and 4 on pages 156–173 and 173–175, respectively, of
this Annual Report.
Derivatives designated as hedges
The Firm applies hedge accounting to certain derivatives executed
for risk management purposes – typically interest rate, foreign
exchange and gold and base metal derivatives, as described above.
JPMorgan Chase does not seek to apply hedge accounting to all of
the derivatives involved in the Firm’s risk management activities.
For example, the Firm does not apply hedge accounting to pur-
chased credit default swaps used to manage the credit risk of loans
and commitments, because of the difficulties in qualifying such
contracts as hedges. For the same reason, the Firm does not apply
hedge accounting to certain interest rate derivatives used for risk
management purposes, or to commodity derivatives used to man-
age the price risk of tolling and load-serving contracts.
To qualify for hedge accounting, a derivative must be highly effec-
tive at reducing the risk associated with the exposure being
hedged. In addition, for a derivative to be designated as a hedge,
the risk management objective and strategy must be documented.
Hedge documentation must identify the derivative hedging instru-
ment, the asset or liability and type of risk to be hedged, and how
the effectiveness of the derivative is assessed prospectively and
retrospectively. To assess effectiveness, the Firm uses statistical
methods such as regression analysis, as well as nonstatistical
methods including dollar-value comparisons of the change in the
fair value of the derivative to the change in the fair value or cash
flows of the hedged item. The extent to which a derivative has
been, and is expected to continue to be, effective at offsetting
changes in the fair value or cash flows of the hedged item must be