JP Morgan Chase 2006 Annual Report Download - page 79

JPMorgan Chase & Co. / 2006 Annual Report 77
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 is identified, measured, monitored, and controlled by an independent
corporate risk governance function. Market risk management seeks to facilitate
efficient risk/return decisions, reduce volatility in operating performance and 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 and performs 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
The Firm’s business segments also have valuation teams whose functions are to
provide independent oversight of the accuracy of the valuations of positions that
expose the Firm to market risk. These valuation functions reside within the market
risk management area and have a reporting line into Finance.
Risk identification and classification
The market risk management group works in partnership with the business
segments to identify market risks throughout the Firm and to refine and mon-
itor market risk policies and procedures. All business segments are responsible
for comprehensive identification and verification of market risks within their
units. Risk-taking businesses have functions that act independently from trad-
ing personnel and are responsible for verifying risk exposures that the busi-
ness takes. In addition to providing independent oversight for market risk
arising from the business segments, Market risk management also is responsi-
ble for identifying exposures which may not be large within individual busi-
ness segments, but which may be large for the Firm in aggregate. Regular
meetings are held between Market risk management 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 Principal transactions revenue. Nontrading risk includes
securities and other assets held for longer-term investment, mortgage servic-
ing rights, and securities and derivatives used to manage the Firm’s asset/liabil-
ity exposures. Unrealized gains and losses in these positions are generally not
reported in Principal transactions revenue.
Trading risk
Fixed income risk (which includes interest rate risk and credit spread risk),
foreign exchange, equities and commodities and other trading risks involve
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.
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
repricing 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, as well as option and basis
risk. Option risk arises primarily from prepayment options embedded in mort-
gages and changes in the probability of newly originated mortgage commit-
ments 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 busi-
ness day the Firm undertakes a comprehensive VAR calculation that includes
both its trading and its nontrading risks. VAR for nontrading risk measures the
amount of potential change in the fair values of the exposures related to these
risks; however, for such risks, VAR is not a measure of reported revenue since
nontrading activities are generally not marked to market through earnings.