JP Morgan Chase 2006 Annual Report Download - page 72

MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.
70 JPMorgan Chase & Co. / 2006 Annual Report
The following table summarizes the aggregate notional amounts and the net derivative receivables MTM for the periods presented.
Notional amounts and derivative receivables marked to market (“MTM”)
Notional amounts(b) Derivative receivables MTM(c)
December 31,
(in billions) 2006 2005 2006 2005
Interest rate $ 50,201 $ 38,493 $29 $28
Foreign exchange 2,520 2,136 43
Equity 809 458 66
Credit derivatives 4,619 2,241 63
Commodity 507 265 11 10
Total, net of cash collateral(a) $ 58,656 $ 43,593 56 50
Liquid securities collateral held against derivative receivables NA NA (7) (6)
Total, net of all collateral NA NA $49 $44
(a) Collateral is only applicable to Derivative receivables MTM amounts.
(b) Represents the sum of gross long and gross short third-party notional derivative contracts, excluding written options and foreign exchange spot contracts.
(c) 2005 has been adjusted to reflect more appropriate product classification of certain balances.
0
10
20
30
40
50
60
70
Exposure profile of derivatives measures
December 31, 2006
(in billions) MDP AVG DRE
1 year 2 years 5 years 10 years
The amount of Derivative receivables reported on the Consolidated balance
sheets of $56 billion and $50 billion at December 31, 2006 and 2005,
respectively, is the amount of the mark-to-market (“MTM”) or fair value of
the derivative contracts after giving effect to legally enforceable master net-
ting agreements and cash collateral held by the Firm and represents the cost
to the Firm to replace the contracts at current market rates should the coun-
terparty default. However, in Management’s view, the appropriate measure of
current credit risk should also reflect additional liquid securities held as collat-
eral by the Firm of $7 billion and $6 billion at December 31, 2006 and 2005,
respectively, resulting in total exposure, net of all collateral, of $49 billion and
$44 billion at December 31, 2006 and 2005, respectively.
The Firm also holds additional collateral delivered by clients at the initiation
of transactions, but this collateral does not reduce the credit risk of the deriv-
ative receivables in the table above. This additional collateral secures potential
exposure that could arise in the derivatives portfolio should the MTM of the
client’s transactions move in the Firm’s favor. As of December 31, 2006 and
2005, the Firm held $12 billion and $10 billion, respectively, of this additional
collateral. The derivative receivables MTM, net of all collateral, also does not
include other credit enhancements in the forms of letters of credit and surety
receivables.
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 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, 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 at both December 31, 2006 and 2005, compared
with derivative receivables MTM, net of all collateral, of $49 billion and $44
billion at December 31, 2006 and 2005, 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.