JP Morgan Chase 2003 Annual Report Download - page 78

M anagement’s discussion and analysis
J.P. M organ Chase & Co.
76 J.P. Morgan Chase & Co. / 2003 Annual Report
commercial portfolio. It is anticipated that the residual compo-
nent w ill range betw een 10% and 20% of the total allow ance
for credit losses.
Fair value of financial instruments
A portion of JPM organ Chase’s assets and liabilities are carried
at fair value, including trading assets and liabilities, AFS securi-
ties and private equity investments. Held-for-sale loans and
mortgage servicing rights are carried at the lower of fair value
or cost. At December 31, 2003, approximately $346 billion of
the Firm’s assets w ere recorded at fair value.
Fair value of a financial instrument is defined as the amount at
w hich the instrument could be exchanged in a current transaction
betw een w illing parties, other than in a forced or liquidation sale.
The majority of the Firm’s assets reported at fair value are based
on quoted market prices or on internally developed models that
are based on independently sourced market parameters, including
interest rate yield curves, option volatilities and currency rates.
The valuation process takes into consideration factors such as
liquidity and concentration concerns and, for the derivative
portfolio, counterparty credit risk. See the discussion of CVA on
page 59 of this Annual Report. M anagement applies judgment
in determining the factors used in the valuation process. For
example, there is often limited market data to rely on w hen
estimating the fair value of a large or aged position. Similarly,
judgment must be applied in estimating prices for less readily
observable external parameters. Finally, other factors such as
model assumptions, market dislocations and unexpected corre-
lations can affect estimates of fair value. Imprecision in estimat-
ing these factors can impact the amount of revenue or loss
recorded for a particular position.
Trading and available-f or-sale portfolios
Substantially all of the Firm’s securities held for trading and
investment purposes (“ long” positions) and securities that the
Firm has sold to other parties but does not ow n (“ short” posi-
tions) are valued based on quoted market prices. How ever, cer-
tain securities are less actively traded and, therefore, are not
alw ays able to be valued based on quoted market prices. The
determination of their fair value requires management judg-
ment, as this determination may require benchmarking to similar
instruments or analyzing default and recovery rates.
As few derivative contracts are listed on an exchange, the majority
of the Firm’s derivative positions are valued using internally devel-
oped models that use as their basis readily observable market
parameters – that is, parameters that are actively quoted and can
be validated to external sources, including industry-pricing services.
Certain derivatives, how ever, are valued based on models w ith
significant unobservable market parameters – that is, parameters
that may be estimated and are, therefore, subject to management
judgment to substantiate the model valuation. These instruments
are normally either less actively traded or trade activity is one-w ay.
Examples include long-dated interest rate or currency swaps,
w here swap rates may be unobservable for longer maturities;
and certain credit products, w here correlation and recovery rates
are unobservable.
M anagement judgment includes recording fair value adjust-
ments (i.e., reductions) to model valuations to account for
parameter uncertainty w hen valuing complex or less actively
traded derivative transactions.
The table below summarizes the Firm’s trading and AFS portfo-
lios by valuation methodology at December 31, 2003:
Trading assets Trading liabilities
Securities Securities AFS
purchased(a) Derivatives(b) sold (a) Derivatives(b) securities
Fair value based on:
Quoted market prices 92% 3% 94% 2% 92%
Internal models with significant observable market parameters 7954963
Internal models with significant unobservable market parameters 12225
To tal 100% 100% 100% 100% 100%
(a) Reflected as Debt and equity instruments on the Firm’s Consolidated balance sheet.
(b) Based on gross MTM values of the Firm’s derivatives portfolio (i.e., prior to netting positions pursuant to FIN 39), as cross-product netting is not relevant to an analysis based on valuation methodologies.
To ensure that the valuations are appropriate, the Firm has vari-
ous controls in place. These include: an independent review and
approval of valuation models; detailed review and explanation
for profit and loss analyzed daily and over time; decomposing
the model valuations for certain structured derivative instru-
ments into their components and benchmarking valuations,
w here possible, to similar products; and validating valuation esti-
mates through actual cash settlement. As markets and products
develop and the pricing for certain derivative products becomes
more transparent, the Firm refines its valuation methodologies.
The Valuation Control Group w ithin the Finance area is responsible
for reviewing the accuracy of the valuations of positions taken
w ithin the Investment Bank.
For a discussion of market risk management, including the
model review process, see M arket Risk M anagement on pages
66–72 of this Annual Report. For further details regarding the
Firm’s valuation methodologies, see Note 31 on pages 120–123
of this Annual Report.