JP Morgan Chase 2010 Annual Report Download - page 191

JPMorgan Chase & Co./2010 Annual Report 191
Note 6 – Derivative instruments
Derivative instruments enable end-users to modify or mitigate
exposure to credit or market risks. Counterparties to a derivative
contract seek to obtain risks and rewards similar to those that
could be obtained from purchasing or selling a related cash instru-
ment without having to exchange upfront the full purchase or sales
price. JPMorgan Chase makes markets in derivatives for customers
and also uses derivatives to hedge or manage its own market risk
exposures. The majority of the Firm’s derivatives are entered into
for market-making purposes.
Trading derivatives
The Firm makes markets in a variety of derivatives in its trading
portfolios to meet the needs of customers (both dealers and clients)
and to generate revenue through this trading activity (“client de-
rivatives”). Customers use derivatives to mitigate or modify interest
rate, credit, foreign exchange, equity and commodity risks. The Firm
actively manages the risks from its exposure to these derivatives by
entering into other derivative transactions or by purchasing or
selling other financial instruments that partially or fully offset the
exposure from client derivatives. The Firm also seeks to earn a
spread between the client derivatives and offsetting positions, and
from the remaining open risk positions.
Risk management derivatives
The Firm manages its market risk exposures using various derivative
instruments.
Interest rate contracts are used to minimize fluctuations in earnings
that are caused by changes in interest rates. Fixed-rate assets and
liabilities appreciate or depreciate in market value as interest rates
change. Similarly, interest income and expense increase or decrease
as a result of variable-rate assets and liabilities resetting to current
market rates, and as a result of the repayment and subsequent
origination or issuance of fixed-rate assets and liabilities at current
market rates. Gains or losses on the derivative instruments that are
related to such assets and liabilities are expected to substantially
offset this variability in earnings. The Firm generally uses interest
rate swaps, forwards and futures to manage the impact of interest
rate fluctuations on earnings.
Foreign currency forward contracts are used to manage the foreign
exchange risk associated with certain foreign currency–
denominated (i.e., non-U.S.) assets and liabilities and forecasted
transactions, as well as the Firm’s net investments in certain non-
U.S. subsidiaries or branches whose functional currencies are not
the U.S. dollar. As a result of fluctuations in foreign currencies, the
U.S. dollar–equivalent values of the foreign currency–denominated
assets and liabilities or forecasted revenue or expense increase or
decrease. Gains or losses on the derivative instruments related to
these foreign currency–denominated assets or liabilities, or forecasted
transactions, are expected to substantially offset this variability.
Commodities based forward and futures contracts are used to
manage the price risk of certain inventory, including gold and base
metals, in the Firm's commodities portfolio. Gains or losses on the
forwards and futures are expected to substantially offset the depre-
ciation or appreciation of the related inventory. Also in the com-
modities portfolio, electricity and natural gas futures and forwards
contracts are used to manage price risk associated with energy-
related tolling and load-serving contracts and investments.
The Firm uses credit derivatives to manage the counterparty credit
risk associated with loans and lending-related commitments. Credit
derivatives compensate the purchaser when the entity referenced in
the contract experiences a credit event, such as bankruptcy or a
failure to pay an obligation when due. For a further discussion of
credit derivatives, see the discussion in the Credit derivatives sec-
tion on pages 197–199 of this Note.
For more information about risk management derivatives, see the
risk management derivatives gains and losses table on page 196 of
this Annual Report, and the hedge accounting gains and losses
tables on pages 194–195 of this Note.
Accounting for derivatives
All free-standing derivatives are required to be recorded on the
Consolidated Balance Sheets at fair value. As permitted under U.S.
GAAP, the Firm nets derivative assets and liabilities, and the related
cash collateral received and paid, when a legally enforceable mas-
ter netting agreement exists between the Firm and the derivative
counterparty. The accounting for changes in value of a derivative
depends on whether or not the transaction has been designated
and qualifies for hedge accounting. Derivatives that are not desig-
nated as hedges are marked to market through earnings. The
tabular disclosures on pages 192–199 of this Note provide addi-
tional information on the amount of, and reporting for, derivative
assets, liabilities, gains and losses. For further discussion of deriva-
tives embedded in structured notes, see Notes 3 and 4 on pages
170–187 and 187–189, respectively, of this Annual Report.
Derivatives designated as hedges
The Firm applies hedge accounting to certain derivatives executed
for risk management purposes – generally interest rate, foreign
exchange and gold and base metal derivatives. However, JPMorgan
Chase does not seek to apply hedge accounting to all of the deriva-
tives involved in the Firm’s risk management activities. For exam-
ple, the Firm does not apply hedge accounting to purchased credit
default swaps used to manage the credit risk of loans and commit-
ments, because of the difficulties in qualifying such contracts as
hedges. For the same reason, the Firm does not apply hedge ac-
counting to certain interest rate and commodity derivatives used for
risk management purposes.
To qualify for hedge accounting, a derivative must be highly effec-
tive at reducing the risk associated with the exposure being
hedged. In addition, for a derivative to be designated as a hedge,
the risk management objective and strategy must be documented.
Hedge documentation must identify the derivative hedging instru-
ment, the asset or liability or forecasted transaction and type of risk
to be hedged, and how the effectiveness of the derivative is as-
sessed prospectively and retrospectively. To assess effectiveness,
the Firm uses statistical methods such as regression analysis, as