JP Morgan Chase 2005 Annual Report Download - page 77

JPMorgan Chase & Co. /2005 Annual Report 75
Market risk management
Market risk is the exposure to an adverse change in the market value of port-
folios and financial instruments caused by a change in market prices or rates.
Market risk management
Market Risk Management (“MRM”) is an independent corporate risk governance
function that identifies, measures, monitors, and controls market risk. It seeks
to facilitate efficient risk/return decisions and to reduce volatility in operating
performance. It strives to make the Firm’s market risk profile transparent to
senior management, the Board of Directors and regulators. Market Risk
Management is overseen by the Chief Risk Officer, a member of the Firm’s
Operating Committee. MRM’s governance structure consists of the following
primary functions:
• Establishment of a comprehensive market risk policy framework
• Independent measurement, monitoring and control
of business segment market risk
• Definition, approval and monitoring of limits
• Performance of stress testing and qualitative risk assessments
In addition, the Firm’s business segments have valuation control functions that
are responsible for ensuring the accuracy of the valuations of positions that
expose the Firm to market risk. These groups report primarily into Finance.
Risk identification and classification
MRM works in partnership with the business segments to identify market
risks throughout the Firm and to refine and monitor market risk policies and
procedures. All business segments are responsible for comprehensive identifi-
cation and verification of market risks within their units. Risk-taking businesses
have functions that act independently from trading personnel and are
responsible for verifying risk exposures that the business takes. In addition
to providing independent oversight for market risk arising from the business
segments, MRM also is responsible for identifying exposures which may not
be large within individual business segments, but which may be large for the
Firm in aggregate. Regular meetings are held between MRM and the heads of
risk-taking businesses to discuss and decide on risk exposures in the context
of the market environment and client flows.
Positions that expose the Firm to market risk can be classified into two cate-
gories: trading and nontrading risk. Trading risk includes positions that are held
by the Firm as part of a business segment or unit whose main business strategy
is to trade or make markets. Unrealized gains and losses in these positions are
generally reported in trading revenue. Nontrading risk includes securities held
for longer term investment, mortgage servicing rights, and securities and
derivatives used to manage the Firm’s asset/liability exposures. Unrealized gains
and losses in these positions are generally not reported in Trading revenue.
Trading risk
Fixed income risk (which includes interest rate risk and credit spread risk)
involves the potential decline in net income or financial condition due to
adverse changes in market rates, whether arising from client activities or
proprietary positions taken by the Firm.
Foreign exchange, equities and commodities risks involve the potential
decline in net income to the Firm due to adverse changes in foreign
exchange, equities or commodities markets, whether arising from client
activities or proprietary positions taken by the Firm.
Nontrading risk
Nontrading risk arises from 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 exposures.
These exposures can result from a variety of factors, including differences
in the timing among the maturity or repricing of assets, liabilities and
off–balance sheet instruments. Changes in the level and shape of market
interest rate curves also may create interest rate risk, since the repricing
characteristics of the Firm’s assets do not necessarily match those of its
liabilities. The Firm also is exposed to basis risk, which is the difference in
re-pricing characteristics of two floating rate indices, such as the prime rate
and 3-month LIBOR. In addition, some of the Firm’s products have embedded
optionality that impact pricing and balances.
The Firm’s mortgage banking activities also give rise to complex interest rate
risks. The interest rate exposure from the Firm’s mortgage banking activities
is a result of changes in the level of interest rates, option and basis risk.
Option risk arises primarily from prepayment options embedded in mortgages
and changes in the probability of newly-originated mortgage commitments
actually closing. Basis risk results from different relative movements between
mortgage rates and other interest rates.
Risk measurement
Tools used to measure risk
Because no single measure can reflect all aspects of market risk, the Firm
uses various metrics, both statistical and nonstatistical, including:
• Nonstatistical risk measures
• Value-at-Risk (“VAR”)
• Loss advisories
• Economic value stress testing
• Earnings-at-risk stress testing
• Risk identification for large exposures (“RIFLE”)
Nonstatistical risk measures
Nonstatistical risk measures other than stress testing include net open positions,
basis point values, option sensitivities, market values, position concentrations
and position turnover. These measures provide granular information on the
Firm’s market risk exposure. They are aggregated by line of business and by risk
type, and are used for monitoring limits, one-off approvals and tactical control.
Value-at-risk
JPMorgan Chase’s primary statistical risk measure, VAR, estimates the potential
loss from adverse market moves in an ordinary market environment and
provides a consistent cross-business measure of risk profiles and levels of
diversification. VAR is used for comparing risks across businesses, monitoring
limits, one-off approvals, and as an input to economic capital calculations.
VAR provides risk transparency in a normal trading environment.
Each business day the Firm undertakes a comprehensive VAR calculation
that includes both its trading and its nontrading activities. VAR for nontrading
activities measures the amount of potential change in fair value of the exposures
related to these activities; however, VAR for such activities is not a measure
of reported revenue since nontrading activities are generally not marked to
market through earnings.