JP Morgan Chase 2003 Annual Report Download - page 73

J.P. Morgan Chase & Co. / 2003 Annual Report 71
Nont rading VAR
For nontrading activities that involve market risk, VAR measures
the amount of potential change in their economic value; how ever,
it is not a measure of reported revenues, since those activities are
not marked to market through earnings.
The increase in average, maximum and December 31 nontrading
portfolio VAR w as primarily attributable to the increase in market
volatility during the 2003 third quarter, and to the rise in interest
rates in the second half of 2003, which increased the sensitivity of
mortgage instruments to the basis risk betw een mortgage rates
and other interest rates.
Economic-value stress t est ing
The Firm conducts both economic-value and NII stress tests on its
nontrading activities. Economic-value stress tests measure the poten-
tial change in the value of these portfolios under the same scenarios
used to evaluate the trading portfolios.
The follow ing table represents the potential worst-case economic-
value stress-test loss (pre-tax) in the Firm’s nontrading portfolio as
predicted by stress-test scenarios:
Nontrading economic-value stress-test loss results – pre-tax
As of or for
the year ended 2003 2002
December 31, At At
(in millions) Avg. Min. Max. Dec. 4 Avg. Min. Max. Dec. 5
Stress-test
loss – pre-tax $(637) $ (392) $(1,130) $ (665) $(967) $ (523) $(1,566) $ (556)
The potential stress-test loss as of December 4, 2003, is the result
of the “ Credit Crunch” stress scenario, which is broadly based on
the events of 1997–98. Under that scenario, political instability in
emerging markets leads to a flight to quality; sovereign bond
yields decline moderately; the U.S. dollar declines against the
euro and Japanese yen; credit spreads w iden sharply; mortgage
spreads w iden; and equity prices decline moderately.
Net int erest income st ress test ing
The follow ing table show s the change in the Firm’s NII over the next
12 months that w ould result from uniform increases or decreases of
100 basis points in all interest rates. It also show s the largest decline
in the Firm’s NII under the same stress-test scenarios utilized for the
trading portfolio. At year-end 2003, JPM organ Chase’s largest poten-
tial NII stress-test loss w as estimated at $160 million, primarily the
result of increased funding costs.
Nontrading NII stress-test loss results – pre-tax
December 31, (in millions) 2003 2002
+/- 100bp parallel change $(160) $(277)
Other stress-test scenarios (88) (133)
Nonst at istical measures
The Firm also calculates exposures to directional interest rate
changes and to changes in the spread betw een the swap curve
and other basis risks. At year-end, the market value of the Firm’s
nontrading positions did not have a significant exposure to
increases or decreases in interest rates. How ever, the Firm’s non-
trading positions maintain an exposure to the spread betw een
mortgage rates and sw ap rates; at year-end the Firm w as
exposed to a w idening of this spread.
Capital allocation for market risk
The Firm allocates market risk capital guided by the principle
that capital should reflect the extent to w hich risks are present
in businesses. Daily VAR, monthly stress-test results and other
factors determine appropriate capital charges for major business
segments. The VAR measure captures a large number of one-day
price moves, while stress tests capture a smaller number of very
large price moves. The Firm allocates market risk capital to each
business segment according to a formula that w eights that seg-
ment’s VAR and stress-test exposures.
Risk monitoring and control
Limit s
M arket risk is primarily controlled through a series of limits. The
sizes of the limits reflect the Firm’s risk appetite after extensive
analyses of the market environment and business strategy. The
analyses examine factors such as market volatility, product liquidity,
business track record, and management experience and depth.
The Firm maintains different levels of limits. Corporate-level
limits encompass VAR calculations and stress-test loss advisories.
Similarly, business-segment levels include limits on VAR calcula-
tions, nonstatistical measurements and P&L loss advisories.
Businesses are responsible for adhering to established limits,
against w hich exposures are monitored and reported daily. An
exceeded limit is reported immediately to senior management,
and the affected business unit must take appropriate action to
comply with the limit. If the business cannot do this w ithin an
acceptable timeframe, senior management is consulted on the
appropriate action.
M RM regularly reviews and updates risk limits, and the Firm’s
Risk M anagement Committee reviews and approves risk limits
at least tw ice a year. M RM further controls the Firm’s exposure
by specifically designating approved financial instruments for
each business unit.