JP Morgan Chase 2010 Annual Report Download - page 126

Management’s discussion and analysis
126 JPMorgan Chase & Co./2010 Annual Report
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. DRE exposure is a measure
that expresses the risk of derivative exposure on a basis intended to
be equivalent to the risk 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 expo-
sure (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 CVA, as further described
below. AVG exposure was $45.3 billion and $49.0 billion at De-
cember 31, 2010 and 2009, respectively, compared with derivative
receivables MTM, net of all collateral, of $64.0 billion and $64.7
billion at December 31, 2010 and 2009, respectively.
The MTM value of the Firm’s derivative receivables incorporates an
adjustment, the CVA, to reflect the credit quality of counterparties.
The CVA is based on the Firm’s AVG to a counterparty and the
counterparty’s credit spread in the credit derivatives market. The
primary components of changes in CVA are credit spreads, new
deal activity or unwinds, and changes in the underlying market
environment. The Firm believes that active risk management is
essential to controlling the dynamic credit risk in the derivatives
portfolio. In addition, the Firm’s credit approval process takes into
consideration the potential for correlation between the Firm’s AVG
to a counterparty and the counterparty’s credit quality. The Firm
risk manages exposure to changes in CVA by entering into credit
derivative transactions, as well as interest rate, foreign exchange,
equity and commodity derivative transactions.
The accompanying graph shows exposure profiles to derivatives
over the next 10 years as calculated by the DRE and AVG metrics.
The two measures generally show declining exposure after the first
year, if no new trades were added to the portfolio.
0
10
20
30
40
50
60
70
80
90
Exposure profile of derivatives measures
December 31, 2010
(in billions) AVG DRE
1 year 2 years 5 years 10 years
The following table summarizes the ratings profile of the Firm’s derivative receivables MTM, net of other liquid securities collateral, for the
dates indicated.
Ratings profile of derivative receivables MTM
Rating equivalent 2010 2009
December 31, Exposure net of % of exposure net Exposure net of % of exposure net
(in millions, except ratios) of all collateral of all collateral of all collateral of all collateral
AAA/Aaa to AA-/Aa3 $ 23,342 36% $ 25,530 40 %
A+/A1 to A-/A3 15,812 25 12,432 19
BBB+/Baa1 to BBB-/Baa3 8,403 13 9,343 14
BB+/Ba1 to B-/B3 13,716 22 14,571 23
CCC+/Caa1 and below 2,722 4 2,815 4
Total $ 63,995 100% $ 64,691 100 %
As noted above, the Firm uses collateral agreements to mitigate
counterparty credit risk in derivatives. The percentage of the Firm’s
derivatives transactions subject to collateral agreements – exclud-
ing foreign exchange spot trades, which are not typically covered by
collateral agreements due to their short maturity – was 88% as of
December 31, 2010, largely unchanged from 89% at December 31,
2009. The Firm posted $58.3 billion and $56.7 billion of collateral
at December 31, 2010 and 2009, respectively.
Credit derivatives
For risk management purposes, the Firm is primarily a purchaser of
credit protection. As a purchaser of credit protection, the Firm has risk
that the counterparty providing the credit protection will default. As a
seller of credit protection, the Firm has risk that the underlying in-
strument referenced in the contract will be subject to a credit event.
The Firm uses credit derivatives for two primary purposes: first, in
its capacity as a market-maker in the dealer/client business to
meet the needs of customers; and second, in order to mitigate
the Firm’s own credit risk associated with its overall derivative
receivables and traditional commercial credit lending exposures
(loans and unfunded commitments).