JP Morgan Chase 2008 Annual Report Download - page 218

Notes to consolidated financial statements
216 JPMorgan Chase & Co./ 2008 Annual Report
Credit default swaps
Credit derivatives may reference the credit of either a single refer-
ence entity (“single-name”) or a broad-based index, as described
further below. The Firm purchases and sells protection on both sin-
gle-name and index-reference obligations. Single-name credit
default swaps (“CDS”) and index CDS contracts are both OTC
derivative contracts. Single-name CDS are used to manage the
default risk of a single reference entity, while CDS index are used
to manage credit risk associated with the broader credit markets or
credit market segments. Like the S&P 500 and other market indices,
a CDS index is comprised of a portfolio of CDS across many refer-
ence entities. New series of CDS indices are established approxi-
mately every six months with a new underlying portfolio of refer-
ence entities to reflect changes in the credit markets. If one of the
reference entities in the index experiences a credit event, then the
reference entity that defaulted is removed from the index and is
replaced with another reference entity. CDS can also be referenced
against specific portfolios of reference names or against cus-
tomized exposure levels based on specific client demands: for
example, to provide protection against the first $1 million of real-
ized credit losses in a $10 million portfolio of exposure. Such
structures are commonly known as tranche CDS.
For both single-name CDS contracts and index CDS, upon the
occurrence of a credit event, under the terms of a CDS contract
neither party to the CDS contract has recourse to the reference
entity. The protection purchaser has recourse to the protection sell-
er for the difference between the face value of the CDS contract
and the fair value of the reference obligation at the time of settling
the credit derivative contract, also known as the recovery value. The
protection purchaser does not need to hold the debt instrument of
the underlying reference entity in order to receive amounts due
under the CDS contract when a credit event occurs.
Credit-linked notes
A credit linked note (“CLN”) is a funded credit derivative where the
issuer of the CLN purchases credit protection on a referenced entity
from the note investor. Under the contract, the investor pays the
issuer par value of the note at the inception of the transaction, and
in return, the issuer pays periodic payments to the investor, based
on the credit risk of the referenced entity. The issuer also repays
the investor the par value of the note at maturity unless the refer-
ence entity experiences a specified credit event. In that event, the
issuer is not obligated to repay the par value of the note, but
rather, the issuer pays the investor the difference between the par
value of the note and the fair value of the defaulted reference obli-
gation at the time of settlement. Neither party to the CLN has
recourse to the defaulting reference entity. For a further discussion
of CLNs, see Note 17 on pages 194–195 of this Annual Report.
The following table presents a summary of the notional amounts of
credit derivatives and credit-linked notes the Firm sold and pur-
chased, and the net position as of December 31, 2008. Upon a
credit event, the Firm as seller of protection would typically pay out
only a percentage of the full notional of net protection sold; as the
amount that is actually required to be paid on the contracts take
into account the recovery value of the reference obligation at the
time of settlement. The Firm manages the credit risk on contracts to
sell protection by purchasing protection with identical or similar
underlying reference entities; as such other protection purchased
referenced in the following table includes credit derivatives bought
on related, but not identical reference positions, including indices,
portfolio coverage and other reference points, which further miti-
gates the risk associated with the net protection sold.