JP Morgan Chase 2010 Annual Report Download - page 142

Management’s discussion and analysis
142 JPMorgan Chase & Co./2010 Annual Report
MARKET RISK MANAGEMENT
Market risk is the exposure to an adverse change in the market
value of portfolios and financial instruments caused by a change in
market prices or rates.
Market risk management
Market Risk is an independent risk management function that
works in close partnership with the business segments to identify
and monitor market risks throughout the Firm and to define market
risk policies and procedures. The risk management function is
headed by the Firm’s Chief Risk Officer.
Market Risk seeks to facilitate efficient risk/return decisions,
reduce volatility in operating performance and provide transpar-
ency into the Firm’s market risk profile for senior management,
the Board of Directors and regulators. Market Risk is responsible
for the following functions:
• establishing a market risk policy framework
• independent measurement, monitoring and control of line-of-
business market risk
• definition, approval and monitoring of limits
• performance of stress testing and qualitative risk assessments
Risk identification and classification
Each line of business is responsible for the comprehensive identifi-
cation and verification of market risks within its units. The Firm’s
market risks arise primarily from the activities in IB, Mortgage
Banking, and CIO in Corporate/Private Equity.
IB makes markets and trades its products across the fixed income,
foreign exchange, equities and commodities markets. This trading
activity may lead to a potential decline in net income due to ad-
verse changes in market rates. In addition to these trading risks,
there are risks in IB’s credit portfolio from retained loans and com-
mitments, derivative credit valuation adjustments, hedges of the
credit valuation adjustments and mark-to-market hedges of the
retained loan portfolio. Additional risk positions result from the
debit valuation adjustments taken on certain structured liabilities
and derivatives to reflect the credit quality of the Firm.
The Firm’s Mortgage Banking business includes the Firm’s mortgage
pipeline and warehouse loans, MSRs and all related hedges. These
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 differences in the relative movements of the rate indices under-
lying mortgage exposure and other interest rates.
CIO is primarily concerned with managing structural risks which
arise out of the various business activities of the Firm. Market Risk
measures and monitors the gross structural exposures as well as
the net exposures related to these activities.
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 nonsta-
tistical, including:
• Value-at-risk (“VaR”)
• Economic-value stress testing
• Nonstatistical risk measures
• Loss advisories
• Revenue drawdowns
• Risk identification for large exposures (“RIFLEs”)
• Earnings-at-risk stress testing
Value-at-risk
JPMorgan Chase utilizes VaR, a statistical risk measure, to estimate
the potential loss from adverse market moves. Each business day,
as part of its risk management activities, the Firm undertakes a
comprehensive VaR calculation that includes the majority of its
material market risks. VaR provides a consistent cross-business
measure of risk profiles and levels of diversification and is used for
comparing risks across businesses and monitoring limits. These VaR
results are reported to senior management and regulators, and they
feed regulatory capital calculations.
The Firm calculates VaR to estimate possible economic outcomes
for current positions using historical data from the previous twelve
months. This approach assumes that historical changes in market
values are representative of current risk; this assumption may not
always be valid. VaR is calculated using a one-day time horizon and
an expected tail-loss methodology, which approximates a 95%
confidence level. This means the Firm would expect to incur losses
greater than that predicted by VaR estimates five times in every
100 trading days, or about 12 to 13 times a year.