JP Morgan Chase 2005 Annual Report Download - page 78

Management’s discussion and analysis
JPMorgan Chase & Co.
76 JPMorgan Chase & Co. /2005 Annual Report
To calculate VAR, the Firm uses historical simulation, which measures risk
across instruments and portfolios in a consistent and comparable way. This
approach assumes that historical changes in market values are representative
of future changes. The simulation is based upon data for the previous twelve
months. The Firm calculates VAR using a one-day time horizon and an expected
tail loss methodology, which approximates a 99% confidence level. This
means the Firm would expect to incur losses greater than that predicted by
VAR estimates only once in every 100 trading days, or about 2.5 times a year.
Trading VAR
IB trading VAR by risk type and credit portfolio VAR(a)
2005 2004(e)
As of or for the year ended Average Minimum Maximum At Average Minimum Maximum At
December 31, (in millions) VAR VAR VAR December 31, VAR VAR VAR December 31,
By risk type:
Fixed income $67 $37 $110 $89 $ 74 $ 45 $ 118 $ 57
Foreign exchange 23 16 32 19 17 10 33 28
Equities 34 15 65 24 28 15 58 20
Commodities and other 21 7 50 34 97188
Less: portfolio diversification (59)(c) NM(d) NM(d) (63)(c) (43)(c) NM(d) NM(d) (41)(c)
Total trading VAR $ 86 $ 53 $ 130 $ 103 $ 85 $ 52 $ 125 $ 72
Credit portfolio VAR(b) 14 11 17 15 14 11 17 15
Less: portfolio diversification (12)(c) NM(d) NM(d) (10)(c) (9)(c) NM(d) NM(d) (9)(c)
Total trading and credit
portfolio VAR $ 88 $ 57 $ 130 $ 108 $ 90 $ 55 $ 132 $ 78
(a) Trading VAR excludes VAR related to the Firm’s private equity business and certain exposures used to manage MSRs. For a discussion of Private equity risk management and MSRs, see page 80
and Note 15 on pages 114–116 of this Annual Report, respectively. Trading VAR includes substantially all mark-to-market trading activities in the IB, plus available-for-sale securities held for the IB’s
proprietary purposes (included within Fixed Income); however, particular risk parameters of certain products are not fully captured, for example, correlation risk.
(b) Includes VAR on derivative credit valuation adjustments, credit valuation adjustment hedges and mark-to-market hedges of the accrual loan portfolio, which are all reported in Trading revenue.
This VAR does not include the accrual loan portfolio, which is not marked to market.
(c) Average and period-end VARs are less than the sum of the VARs of its market risk components, which is due to risk offsets resulting from portfolio diversification. The diversification effect reflects
the fact that the risks are not perfectly correlated. The risk of a portfolio of positions is therefore usually less than the sum of the risks of the positions themselves.
(d) Designated as not meaningful (“NM”) because the minimum and maximum may occur on different days for different risk components, and hence it is not meaningful to compute a portfolio
diversification effect.
(e) 2004 results include six months of the combined Firm’s results and six months of heritage JPMorgan Chase results.
IB‘s Average Total Trading and Credit Portfolio VAR decreased to $88 million
during 2005 compared with $90 million for the same period in 2004. Period-
end VAR increased over the same period to $108 million from $78 million.
Commodities and other VAR increased due to the expansion of the energy
trading business. The decrease in average Total Trading and Credit Portfolio
VAR was driven by increased portfolio diversification as fixed income risk
decreased and foreign exchange, equities and commodities risk increased.
Trading VAR diversification increased to $59 million, or 41% of the sum of
the components, from $43 million, or 34% of the sum of the components.
The diversification effect between the trading portfolio and the credit portfolio
also increased to $12 million, or 12% of the sum of the components, from
$9 million, or 9% of the sum of the components. In general, over the course
of the year, VAR exposures can vary significantly as trading positions change,
market volatility fluctuates and diversification benefits change.
VAR backtesting
To evaluate the soundness of its VAR model, the Firm conducts daily backtesting
of VAR against daily financial results, based upon market risk-related revenue.
Market risk-related revenue is defined as the change in value of the mark-to-
market trading portfolios plus any trading-related net interest income, brokerage
commissions, underwriting fees or other revenue. The following histogram
illustrates the daily market risk-related gains and losses for the IB trading
businesses for the year ended December 31, 2005. The chart shows that the
IB posted market risk-related gains on 208 out of 260 days in this period,
with 20 days exceeding $100 million. The inset graph looks at those days
on which the IB experienced losses and depicts the amount by which VAR
exceeded the actual loss on each of those days. Losses were sustained on 52
days, with no loss greater than $90 million, and with no loss exceeding the
VAR measure.