JP Morgan Chase 2003 Annual Report Download - page 61

J.P. Morgan Chase & Co. / 2003 Annual Report 59
The $34 trillion of notional principal of the Firm’s derivative con-
tracts outstanding at December 31, 2003, significantly exceeds
the possible credit losses that could arise from such transactions.
For most derivative transactions, the notional principal amount
does not change hands; it is simply used as a reference to calcu-
late payments. In terms of current credit risk exposure, the
appropriate measure of risk is the M TM value of the contract.
The M TM exposure represents the cost to replace the contracts
at current market rates should the counterparty default. When
JPM organ Chase has more than one transaction outstanding
w ith a counterparty, and a legally enforceable master netting
agreement exists w ith the counterparty, the M TM exposure, less
collateral held, represents, in the Firm’s view, the appropriate
measure of current credit risk w ith that counterparty as of the
reporting date. At December 31, 2003, the M TM value of deriv-
ative receivables (after taking into account the effects of legally
enforceable master netting agreements) w as $84 billion. Further,
after taking into account $36 billion of collateral held by the
Firm, the net current M TM credit exposure w as $48 billion.
While useful as a current view of credit exposure, the net
M TM value of the derivative receivables does not capture the
potential future variability of that credit exposure. To capture
the potential future variability of credit exposure, the Firm
calculates, on a client-by-client basis, three measures of
potential derivatives-related credit loss: Peak, Derivative
Risk Equivalent (“ DRE” ) and Average exposure (“ AVG” ).
This last measure is used as the basis for the Firm’s Economic
credit exposure as defined on page 53 of this Annual Report.
These measures all incorporate netting and collateral benefits
w here applicable.
Peak exposure to a counterparty is an extreme measure of
exposure calculated at a 97.5% confidence level. How ever, the
total potential future credit risk embedded in the Firm' s deriva-
tives portfolio is not the simple sum of all Peak client credit
risks. This is because, at the portfolio level, credit risk is reduced
by the fact that w hen offsetting transactions are done with sep-
arate counterparties, only one of the tw o trades can generate a
credit loss even if both counterparties w ere to default simulta-
neously. The Firm refers to this effect as market diversification,
and the M arket-Diversified Peak (“ M DP” ) measure is a port-
folio aggregation of counterparty Peak measures, representing
the maximum losses at the 97.5% confidence level that w ould
occur if all counterparties defaulted under any one given market
scenario and timeframe.
Derivative Risk Equivalent exposure is a measure that expresses
the riskiness of derivative exposure on a basis intended to be
equivalent to the riskiness of loan exposures. This is done by
equating the unexpected loss in a derivative counterparty expo-
sure (which takes into consideration both the loss volatility and
the credit rating of the counterparty) with the unexpected loss in
a loan exposure (which takes into consideration only the credit
rating of the counterparty). DRE is a less extreme measure of the
potential credit loss than Peak, and is the primary measure used
by the Firm for credit approval of derivative transactions.
Finally, as described on page 53 of this Annual Report, Average
exposure is a measure of the expected M TM value of the Firm’s
derivative receivables at future time periods. The three-year
average of the AVG is the basis of the Firm’s Economic credit
exposure, w hile AVG exposure over the total life of the deriva-
tive contract is used as the primary metric for pricing purposes
and is used to calculate credit capital and the Credit Valuation
Adjustment (“ CVA” ).
The chart below show s the exposure profiles to derivatives over
the next 10 years as calculated by the M DP, DRE and AVG met-
rics. All three measures generally show declining exposure after
the first year, if no new trades were added to the portfolio.
$ 0
$10
$20
$30
$40
$50
$60
1 year 2 years 5 years 10 years
MDP AVGAVG
DREDRE
Exposure profile of derivatives measures
December 31, 2003
(in billions)
$48
The M TM value of the Firm’s derivative receivables incorporates
an adjustment to reflect the credit quality of counterparties. This
is called CVA and w as $635 million as of December 31, 2003,
compared w ith $1.3 billion at December 31, 2002. The CVA is
based on the Firm’s AVG to a counterparty, and on the counter-
party’s credit spread in the credit derivatives market. The primary
components of changes in CVA are credit spreads, new deal
activity or unw inds, and changes in the underlying market envi-
ronment. The CVA decrease in 2003 w as primarily due to the dra-
matic reduction in credit spreads during the year. For a discussion
of the impact of CVA on Trading revenue, see portfolio manage-
ment activity on pages 60–61 of this Annual Report.
The Firm believes that active risk management is essential to
controlling the dynamic credit risk in the derivatives portfolio.
The Firm hedges its exposure to changes in CVA by entering into
credit derivative transactions, as w ell as interest rate, foreign
exchange, equity and commodity derivatives transactions.