JP Morgan Chase 2003 Annual Report Download - page 118

Notes to consolidated financial statements
J.P. M organ Chase & Co.
116 J.P. Morgan Chase & Co./ 2003 Annual Report
Derivatives designated as hedges for accounting purposes must
be considered highly effective at reducing the risk associated
w ith the exposure being hedged. Each derivative must be desig-
nated as a hedge, w ith documentation of the risk management
objective and strategy, including identification of the hedging
instrument, the hedged item and the risk exposure, and how
effectiveness is to be assessed prospectively and retrospectively.
For qualifying fair value hedges, all changes in the fair value of
the derivative and changes in the fair value of the hedged item
for the risk being hedged are recognized in earnings. If the
hedge relationship is terminated, then the fair value adjustment
to the hedged item continues to be reported as part of the basis
of the item and is amortized to earnings as a yield adjustment.
For qualifying cash flow hedges, the effective portion of the
change in the fair value of the derivative is recorded in Other
comprehensive income and recognized in the income statement
w hen the hedged cash flow s affect earnings. The ineffective
portions of cash flow hedges are immediately recognized in
earnings. If the hedge relationship is terminated, then the
change in fair value of the derivative recorded in Other compre-
hensive income is recognized w hen the cash flow s that w ere
hedged occur, consistent w ith the original hedge strategy. For
hedge relationships discontinued because the forecasted trans-
action is not expected to occur according to the original strategy,
any related derivative amounts recorded in Other comprehensive
income are immediately recognized in earnings. For qualifying
net investment hedges, changes in the fair value of the deriva-
tive or the revaluation of the foreign currency–denominated
debt instrument are recorded in the translation adjustments
account within Other comprehensive income.
JPM organ Chase’s fair value hedges primarily include hedges
of fixed-rate long-term debt, loans, AFS securities and M SRs.
Interest rate swaps are the most common type of derivative
contract used to modify exposure to interest rate risk, convert-
ing fixed-rate assets and liabilities to a floating rate. Interest rate
options and swaptions are also used in combination w ith inter-
est rate swaps to hedge the fair value of the Firm’s M SRs. For a
further discussion of hedging, see Note 16 on page 108 of this
Annual Report. All amounts have been included in earnings
consistent w ith the classification of the hedged item, primarily
Net interest income, M ortgage fees and related income and
Other revenue. JPM organ Chase did not recognize any gains or
losses during 2003 on firm commitments that no longer qualify
as fair value hedges.
JPM organ Chase also enters into derivative contracts to hedge
exposure to variability in cash flow s from floating-rate financial
instruments and forecasted transactions, primarily the rollover of
short-term assets and liabilities, foreign currency denominated
revenues and expenses and anticipated securities transactions.
Interest rate swaps, futures, options and forw ard contracts are the
most common instruments used to reduce the impact of interest
rate and foreign exchange rate changes on future earnings. All
amounts have been included in earnings consistent w ith the
classification of the hedged item, primarily Net interest income.
JPM organ Chase and its subsidiaries are named as defendants in
a number of legal actions and governmental proceedings arising
in connection w ith their respective businesses. Additional
actions, investigations or proceedings may be brought from time
to time in the future. In view of the inherent difficulty of pre-
dicting the outcome of legal matters, particularly w here the
claimants seek very large or indeterminate damages or w here
the cases present novel legal theories or involve a large number
of parties, the Firm cannot state with confidence w hat the even-
tual outcome of the pending matters w ill be, w hat the timing of
the ultimate resolution of these matters w ill be or w hat the
eventual loss related to each pending matter w ill be. Subject to
the foregoing caveat, JPM organ Chase anticipates, based upon
its current know ledge, after consultation w ith counsel and
after taking into account its current litigation reserves, that the
outcome of the legal actions, proceedings and investigations
currently pending against it should not have a material adverse
effect on the consolidated financial condition of the Firm.
How ever, the outcome of a particular proceeding or the imposi-
tion of a particular fine or penalty may be material to the Firm’s
operating results for a particular period depending upon,
among other factors, the size of the loss or liability and the level
of the Firm’s income for that period.
Accounting for derivative instruments
and hedging activities
Derivative instruments enable end-users to increase, reduce or
alter exposure to credit or market risks. The value of a derivative
is derived from its reference to an underlying variable or combi-
nation of variables such as equity, foreign exchange, credit,
commodity or interest rate prices or indices. JPM organ Chase
makes markets in derivatives for its customers, and also is an
end user of derivatives in order to manage the Firm’s exposure
to credit and market risks.
SFAS 133, as amended by SFAS 138 and SFAS 149, establishes
accounting and reporting standards for derivative instruments,
including derivative instruments embedded in other contracts
used for trading and hedging activities. All derivatives, w hether
designated for hedging relationships or not, are required to
be recorded on the balance sheet at fair value. The accounting
for changes in value of a derivative depends on w hether the
contract is for trading purposes or has been designated and
qualifies for hedge accounting. In order to qualify for hedge
accounting, a derivative must be highly effective at reducing the
risk associated with the exposure being hedged. The majority of
JPM organ Chase’s derivatives are entered into for trading pur-
poses. The Firm also uses derivatives as an end-user to hedge
market exposures, modify the interest rate characteristics of
related balance sheet instruments or meet longer-term invest-
ment objectives. Both trading and end-user derivatives are
recorded at fair value in Trading assets and Trading liabilities.
Note 28