JP Morgan Chase 2006 Annual Report Download - page 82

80 JPMorgan Chase & Co. / 2006 Annual Report
Immediate changes in interest rates present a limited view of risk, and so a
number of alternative scenarios also are reviewed. These scenarios include the
implied forward curve, nonparallel rate shifts and severe interest rate shocks
on selected key rates. These scenarios are intended to provide a comprehensive
view of JPMorgan Chase’s earnings-at-risk over a wide range of outcomes.
JPMorgan Chase’s 12-month pretax earnings sensitivity profile as of
December 31, 2006 and 2005, were as follows:
Immediate change in rates
(in millions) +200bp +100bp -100bp -200bp
December 31, 2006 $ (101) $ 28 $ (21) $(182)
December 31, 2005 265 172 (162) (559)
The primary change in earnings-at-risk from December 31, 2005, reflects a
higher level of AFS securities and other repositioning. The Firm is exposed to
both rising and falling rates. The Firm’s risk to rising rates is largely the result
of increased funding costs. In contrast, the exposure to falling rates is the
result of higher anticipated levels of loan and securities prepayments.
Risk identification for large exposures (“RIFLE”)
Individuals who manage risk positions, particularly those that are complex,
are responsible for identifying potential losses that could arise from specific,
unusual events, such as a potential tax change, and estimating the probabilities
of losses arising from such events. This information is entered into the Firm’s
RIFLE database. Trading management has access to RIFLE, thereby permitting
the Firm to monitor further earnings vulnerability not adequately covered by
standard risk measures.
Risk monitoring and control
Limits
Market risk is controlled primarily through a series of limits. Limits reflect the
Firm’s risk appetite in the context of the market environment and business
strategy. In setting limits, the Firm takes into consideration factors such as mar-
ket volatility, product liquidity, business trends and management experience.
Market risk management regularly reviews and updates risk limits. Senior
management, including the Firm’s Chief Executive Officer and Chief Risk
Officer, is responsible for reviewing and approving risk limits at least once a
year. Market risk management further controls the Firm’s exposure by specifi-
cally designating approved financial instruments and tenors, known as instru-
ment authorities, for each business segment.
The Firm maintains different levels of limits. Corporate-level limits include VAR
and stress. Similarly, line-of-business limits include VAR and stress limits and
may be supplemented by loss advisories, nonstatistical measurements and
instrument authorities. Businesses are responsible for adhering to established
limits, against which exposures are monitored and reported. Limit breaches
are reported in a timely manner to senior management, and the affected
business segment is required either to reduce trading positions or consult with
senior management on the appropriate action.
Qualitative review
The market risk management group also performs periodic reviews as neces-
sary of both businesses and products with exposure to market risk in order to
assess the ability of the businesses to control their market risk. Strategies,
market conditions, product details and risk controls are reviewed, and specific
recommendations for improvements are made to management.
Model review
Some of the Firm’s financial instruments cannot be valued based upon quoted
market prices but are instead valued using pricing models. Such models are
used for management of risk positions, such as reporting against limits, as well
as for valuation. The Model Risk Group, independent of the businesses and
market risk management, reviews the models the Firm uses and assesses
model appropriateness and consistency. The model reviews consider a number
of factors about the model’s suitability for valuation and risk management of
a particular product, including whether it accurately reflects the characteristics
of the transaction and its significant risks, the suitability and convergence
properties of numerical algorithms, reliability of data sources, consistency of
the treatment with models for similar products, and sensitivity to input param-
eters and assumptions that cannot be priced from the market.
Reviews are conducted of new or changed models, as well as previously
accepted models, to assess whether there have been any changes in the
product or market that may impact the model’s validity and whether there
are theoretical or competitive developments that may require reassessment
of the model’s adequacy. For a summary of valuations based upon models,
see Critical Accounting Estimates used by the Firm on pages 83–85 of this
Annual Report.
Risk reporting
Nonstatistical exposures, value-at-risk, loss advisories and limit excesses are
reported daily for each trading and nontrading business. Market risk exposure
trends, value-at-risk trends, profit and loss changes, and portfolio concentra-
tions are reported weekly. Stress-test results are reported monthly to business
and senior management.
MANAGEMENT’S DISCUSSION AND ANALYSIS
JPMorgan Chase & Co.