JP Morgan Chase 2012 Annual Report Download - page 147

JPMorgan Chase & Co./2012 Annual Report 157
In addition to the collateral described in the preceding
paragraph, the Firm also holds additional collateral
(including cash, U.S. government and agency securities, and
other G7 government bonds) delivered by clients at the
initiation of transactions, as well as collateral related to
contracts that have a non-daily call frequency and collateral
that the Firm has agreed to return but has not yet settled as
of the reporting date. Though this collateral does not
reduce the balances and is not included in the table above,
it is available as security against potential exposure that
could arise should the fair value of the client’s derivative
transactions move in the Firm’s favor. As of December 31,
2012 and 2011, the Firm held $22.6 billion and $17.6
billion, respectively, of this additional collateral. The
derivative receivables, net of all collateral, also does not
include other credit enhancements, such as letters of credit.
For additional information on the Firm’s use of collateral
agreements, see Note 6 on pages 218–227 of this Annual
Report.
While useful as a current view of credit exposure, the net
fair 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 exposure (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 fair 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. The three
year AVG exposure was $42.3 billion and $53.6 billion at
December 31, 2012 and 2011, respectively, compared with
derivative receivables, net of all collateral, of $61.3 billion
and $70.7 billion at December 31, 2012 and 2011,
respectively.
The fair 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 risk
management process takes into consideration the potential
impact of wrong-way risk, which is broadly defined as the
potential for increased correlation between the Firm’s
exposure to a counterparty (AVG) and the counterparty’s
credit quality. Many factors may influence the nature and
magnitude of these correlations over time. To the extent
that these correlations are identified, the Firm may adjust
the CVA associated with that counterparty’s AVG. 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 that
exposure will decline after the first year, if no new trades
are added to the portfolio.