JP Morgan Chase 2003 Annual Report Download - page 72

M anagement’s discussion and analysis
J.P. M organ Chase & Co.
70 J.P. Morgan Chase & Co. / 2003 Annual Report
Trading Risk
Major risks
Interest rates: Interest rate risk (which includes credit spread risk)
involves the potential decline in net income or financial condition
due to adverse changes in market interest rates, w hich may result
in changes to NII, securities valuations, and other interest-sensitive
revenues and expenses.
Foreign exchange, equities and commodities: These risks
involve the potential decline in net income or financial condition
due to adverse changes in foreign exchange, equities or commodi-
ties markets, w hether due to proprietary positions taken by the
Firm, or due to a decrease in the level of client activity.
Hedge fund investments: The Firm invests in numerous hedge
funds that have various strategic goals, investment strategies,
industry concentrations, portfolio sizes and management styles.
Fund investments are passive long-term investments. Individual
hedge funds may have exposure to interest rate, foreign exchange,
equity and commodity risk w ithin their portfolio risk structures.
Trading VAR
The largest contributor to trading VAR w as interest rate risk.
Before portfolio diversification, interest rate risk accounted for
roughly 60% of the average Trading Portfolio VAR. The diversifi-
cation effect, w hich on average reduced the daily average Trading
Portfolio VAR by $38 million in 2003, reflects the fact that the
largest losses for different positions and risks do not typically
occur at the same time. The risk of a portfolio of positions is
therefore usually less than the sum of the risks of the positions
themselves. The degree of diversification is determined both by
the extent to w hich different market variables tend to move
together, and by the extent to w hich different businesses have
similar positions.
The increase in year-end VAR w as driven by an increase in the
VAR for equities risk, w hich w as attributable to a significant
increase in customer-driven business in equity options. In general,
over the course of a year, VAR exposures can vary significantly as
trading positions change and market volatility fluctuates.
Economic-value stress t est ing
The follow ing table represents the w orst-case potential economic-
value stress-test loss (pre-tax) in the Firm’s trading portfolio as pre-
dicted by stress-test scenarios:
Trading economic-value stress-test loss results – pre-tax
As of or for
the year ended 2003 2002(a)
December 31, At At
(in millions) Avg. Min. Max. Dec. 4 Avg. Min. Max. Dec. 5
Stress-test
loss – pre-tax $(508) $ (255) $(888) $ (436) $(405) $ (103) $ (715) $ (219)
(a) Amounts have been revised to reflect the reclassification of certain mortgage banking
positions from the trading portfolio to the nontrading portfolio.
The potential stress-test loss as of December 4, 2003, is the result of
the “ Equity M arket Collapse” stress scenario, which is broadly mod-
eled on the events of October 1987. Under this scenario, global
equity markets suffer a sharp reversal after a long sustained rally;
equity prices decline globally; volatilities for equities, interest rates
and credit products increase dramatically for short maturities and
less so for longer maturities; sovereign bond yields decline moder-
ately; and sw ap spreads and credit spreads w iden moderately.
Nontrading Risk
Major risk – Interest rat es
The execution of the Firm’s core business strategies, the delivery
of products and services to its customers, and the discretionary
positions the Firm undertakes to risk-manage structural exposures
give rise to interest rate risk in its nontrading activities.
This exposure can result from a variety of factors, including differ-
ences in the timing betw een the maturity or repricing of assets,
liabilities and off–balance sheet instruments. Changes in the level
and shape of interest rate curves may also create interest rate risk,
since the repricing characteristics of the Firm’s assets do not neces-
sarily match those of its liabilities. The Firm is also exposed to basis
risk, which is the difference in the repricing characteristics of tw o
floating-rate indices, such as the prime rate and 3-month LIBOR. In
addition, some of the Firm’s products have embedded optionality
that may have an impact on pricing and balance levels.
The Firm manages exposure in its structural interest rate activities
on a consolidated, corporate-w ide basis. Business units transfer
their interest rate risk to Global Treasury through a transfer pricing
system, w hich takes into account the elements of interest rate
exposure that can be hedged in financial markets. These elements
include current balance and contractual rates of interest, con-
tractual principal payment schedules, expected prepayment
experience, interest rate reset dates and maturities and rate
indices used for re-pricing. All transfer pricing assumptions are
reviewed on a semiannual basis and must be approved by the
Firm’s Capital Committee.
The Firm’s mortgage banking activities also give rise to complex
interest rate risks. The interest rate exposure from the Firm’s mort-
gage banking activities is a result of option and basis risks. Option
risk arises from prepayment features in mortgages and M SRs, and
from the probability of new ly originated mortgage commitments
actually closing. Basis risk results from different relative movements
betw een mortgage rates and other interest rates. These risks
are managed through hedging programs specific to the different
mortgage banking activities. Potential changes in the market
value of M SRs and increased amortization levels of M SRs are
managed via a risk management program that attempts to offset
changes in the market value of M SRs w ith changes in the market
value of derivatives and investment securities. A similar approach
is implemented to manage the interest rate and option risks
associated w ith the Firm’s mortgage origination business.