JP Morgan Chase 2005 Annual Report Download - page 70

Notional amounts and derivative receivables marked to market (“MTM”)
Notional amounts(a) Derivative receivables MTM
As of December 31,
(in billions) 2005 2004 2005 2004
Interest rate $ 38,493 $ 37,022 $30 $46
Foreign exchange 2,136 1,886 38
Equity 458 434 66
Credit derivatives 2,241 1,071 43
Commodity 265 101 73
Total $ 43,593 $ 40,514 50 66
Collateral held against derivative receivables NA NA (6) (9)
Exposure net of collateral NA NA $44
(b) $57 (c)
(a) The notional amounts represent the gross sum of long and short third-party notional derivative contracts, excluding written options and foreign exchange spot contracts, which significantly exceed
the possible credit losses that could arise from such transactions. For most derivative transactions, the notional principal amount does not change hands; it is used simply as a reference to calculate
payments.
(b) The Firm held $33 billion of collateral against derivative receivables as of December 31, 2005, consisting of $27 billion in net cash received under credit support annexes to legally enforceable master
netting agreements, and $6 billion of other liquid securities collateral. The benefit of the $27 billion is reflected within the $50 billion of derivative receivables MTM. Excluded from the $33 billion of
collateral is $10 billion of collateral delivered by clients at the initiation of transactions; this collateral secures exposure that could arise in the derivatives portfolio should the MTM of the client’s
transactions move in the Firm’s favor. Also excluded are credit enhancements in the form of letters of credit and surety receivables.
(c) The Firm held $41 billion of collateral against derivative receivables as of December 31, 2004, consisting of $32 billion in net cash received under credit support annexes to legally enforceable master
netting agreements, and $9 billion of other liquid securities collateral. The benefit of the $32 billion is reflected within the $66 billion of derivative receivables MTM. Excluded from the $41 billion of
collateral is $10 billion of collateral delivered by clients at the initiation of transactions; this collateral secures exposure that could arise in the derivatives portfolio should the MTM of the client’s
transactions move in the Firm’s favor. Also excluded are credit enhancements in the form of letters of credit and surety receivables.
Management’s discussion and analysis
JPMorgan Chase & Co.
68 JPMorgan Chase & Co. /2005 Annual Report
0
$10
$20
$30
$40
$50
$60
$70
1 year 2 years 5 years 10 years
MDP AVGAVG
DREDRE
Exposure profile of derivatives measures
December 31, 2005
(in billions)
$44
The following table summarizes the aggregate notional amounts and the reported derivative receivables (i.e., the MTM or fair value of the derivative contracts after
taking into account the effects of legally enforceable master netting agreements) at each of the dates indicated:
The MTM of derivative receivables contracts represents the cost to replace
the contracts at current market rates should the counterparty default. When
JPMorgan Chase has more than one transaction outstanding with a counter-
party, and a legally enforceable master netting agreement exists with that
counterparty, the netted MTM exposure, less collateral held, represents, in
the Firm’s view, the appropriate measure of current credit risk.
While useful as a current view of credit exposure, the net MTM 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”). These measures all incorporate netting and collateral
benefits, where applicable.
Peak exposure to a counterparty is an extreme measure of exposure calculated
at a 97.5% confidence level. However, the total potential future credit risk
embedded in the Firm’s derivatives 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 when offsetting transactions are done with separate counter-
parties, only one of the two trades can generate a credit loss, even if both
counterparties were to default simultaneously. The Firm refers to this effect
as market diversification, and the Market-Diversified Peak (“MDP”) measure
is a portfolio aggregation of counterparty Peak measures, representing the
maximum losses at the 97.5% confidence level that would occur if all coun-
terparties defaulted under any one given market scenario and time frame.
Derivative Risk Equivalent (“DRE”) exposure is a measure that expresses
the riskiness of derivative exposure on a basis intended to be equivalent to
the riskiness of loan exposures. The measurement is done by equating the
unexpected loss in a derivative counterparty exposure (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
potential credit loss than Peak and is the primary measure used by the Firm
for credit approval of derivative transactions.
Finally, Average exposure (“AVG”) is a measure of the expected MTM value of the
Firm’s derivative receivables at future time periods, including the benefit of
collateral. AVG exposure over the total life of the derivative contract is used as
the primary metric for pricing purposes and is used to calculate credit capital
and the Credit Valuation Adjustment (“CVA”), as further described below.
Average exposure was $36 billion and $38 billion at December 31, 2005 and
2004, respectively, compared with derivative receivables MTM net of other
highly liquid collateral of $44 billion and $57 billion at December 31, 2005
and 2004, respectively.
The graph below shows exposure profiles to derivatives over the next
10 years as calculated by the MDP, DRE and AVG metrics.All three measures
generally show declining exposure after the first year, if no new trades were
added to the portfolio.