JP Morgan Chase 2008 Annual Report Download - page 216

Notes to consolidated financial statements
214 JPMorgan Chase & Co./ 2008 Annual Report
Note 32 – Accounting for derivative instru-
ments and hedging activities
Derivative instruments enable end-users to increase, reduce or alter
exposure to credit or market risks. The value of a derivative is derived
from its reference to an underlying variable or combination of variables
such as equity, foreign exchange, credit, commodity or interest rate
prices or indices. JPMorgan Chase makes markets in derivatives for
customers and also is an end-user of derivatives in order to hedge or
manage risks of market exposures, modify the interest rate character-
istics of related balance sheet instruments or meet longer-term
investment objectives. The majority of the Firm’s derivatives are
entered into for market-making purposes. SFAS 133, as amended by
SFAS 138, SFAS 149, SFAS 155 and FSP FAS 133-1, establishes
accounting and reporting standards for derivative instruments,
including those used for trading and hedging activities and derivative
instruments embedded in other contracts. All free-standing deriva-
tives are required to be recorded on the Consolidated Balance Sheets
at fair value. The accounting for changes in value of a derivative
depends on whether or not the contract has been designated and
qualifies for hedge accounting. Derivative receivables and payables,
whether designated for hedging relationships or not, are recorded in
trading assets and trading liabilities as set forth in Note 6 on page
159 of this Annual Report.
Derivatives used for trading purposes
The Firm makes markets in derivatives for customers seeking to mod-
ify, or reduce interest rate, credit, foreign exchange, equity and com-
modity and other market risks or for risk-taking purposes. The Firm
typically manages its exposure from such derivatives by entering into
derivatives or other financial instruments that partially or fully offset
the exposure from the client transaction. The Firm actively manages
any residual exposure and seeks to earn a spread between the client
derivatives and offsetting positions. For the Firm’s own account, the
Firm uses derivatives to take risk positions or to benefit from differ-
ences in prices between derivative markets and markets for other
financial instruments.
Derivatives used for risk management purposes
Interest rate contracts, which are generally interest rate swaps, for-
wards and futures are utilized in the Firm’s risk management activi-
ties to minimize fluctuations in earnings caused by interest rate
volatility. As a result of interest rate fluctuations, fixed-rate assets
and liabilities appreciate or depreciate in market value. Gains or loss-
es on the derivative instruments that are linked to fixed-rate assets
and liabilities and forecasted transactions are expected to offset sub-
stantially this unrealized appreciation or depreciation. Interest
income and interest expense on variable-rate assets and liabilities
and on forecasted transactions increase or decrease as a result of
interest rate fluctuations. Gains and losses on the derivative instru-
ments that are linked to assets and liabilities and forecasted transac-
tions are expected to offset substantially this variability in earnings.
Interest rate swaps involve the exchange of fixed-rate and variable-
rate interest payments based on the contracted notional amount.
Forward contracts used for the Firm’s interest rate risk management
activities are primarily arrangements to exchange cash in the future
based on price movements of specified financial instruments. Futures
contracts used are primarily index futures which provide for cash
payments based upon the movements of an underlying rate index.
The Firm uses foreign currency contracts to manage the foreign
exchange risk associated with certain foreign currency-denominated
(i.e., non-U.S.) assets and liabilities and forecasted transactions
denominated in a foreign currency, as well as the Firm’s equity
investments in foreign subsidiaries. As a result of foreign currency
fluctuations, the U.S. dollar equivalent values of the foreign currency-
denominated assets and liabilities or forecasted transactions change.
Gains or losses on the derivative instruments that are linked to the
foreign currency denominated assets or liabilities or forecasted trans-
actions are expected to offset substantially this variability. Foreign
exchange forward contracts represent agreements to exchange the
currency of one country for the currency of another country at an
agreed-upon price on an agreed-upon settlement date.
The Firm uses forward contracts to manage the overall price risk
associated with the gold inventory in its commodities portfolio. As a
result of gold price fluctuations, the fair value of the gold inventory
changes. Gains or losses on the derivative instruments that are linked
to gold inventory are expected to substantially offset this unrealized
appreciation or depreciation. Forward contracts used for the Firm’s
gold inventory risk management activities are arrangements to deliv-
er gold in the future.
The Firm uses credit derivatives to manage the credit risk associated
with loans, lending-related commitments and derivative receivables,
as well as exposure to residential and commercial mortgages. Credit
derivatives compensate the purchaser when the entity referenced in
the contract experiences a credit event such as bankruptcy or a fail-
ure to pay an obligation when due. For a further discussion of credit
derivatives, see the discussion below.
In order to qualify for hedge accounting, a derivative must be consid-
ered highly effective at reducing the risk associated with the expo-
sure being hedged. In order for a derivative to be designated as a
hedge, there must be documentation of the risk management objec-
tive and strategy, including identification of the hedging instrument,
the hedged item and the risk exposure, and how effectiveness is to
be assessed prospectively and retrospectively. To assess effectiveness,
the Firm uses statistical methods such as regression analysis, as well
as nonstatistical methods including dollar value comparisons of the
change in the fair value of the derivative to the change in the fair
value or cash flows of the hedged item. The extent to which a hedg-
ing instrument has been and is expected to continue to be effective
at achieving offsetting changes in fair value or cash flows must be
assessed and documented at least quarterly. Any ineffectiveness must
be reported in current-period earnings. If it is determined that a
derivative is not highly effective at hedging the designated exposure,
hedge accounting is discontinued.
For qualifying fair value hedges, all changes in the fair value of the
derivative and in the fair value of the hedged item for the risk being
hedged are recognized in earnings. If the hedge relationship is termi-
nated, then the fair value adjustment to the hedged item continues