JP Morgan Chase 2012 Annual Report Download - page 187

JPMorgan Chase & Co./2012 Annual Report 197
level 1 of the fair value hierarchy (see below for further
information on the fair value hierarchy). For other
positions, judgment is required to assess the need for
valuation adjustments to appropriately reflect liquidity
considerations, unobservable parameters, and, for certain
portfolios that meet specified criteria, the size of the net
open risk position. The determination of such adjustments
follows a consistent framework across the Firm:
• Liquidity valuation adjustments are considered when the
Firm may not be able to observe a recent market price for
a financial instrument that trades in an inactive (or less
active) market. The Firm estimates the amount of
uncertainty in the initial fair value estimate based on the
degree of liquidity in the market. Factors considered in
determining the liquidity adjustment include: (1) the
amount of time since the last relevant pricing point; (2)
whether there was an actual trade or relevant external
quote or alternatively pricing points for similar
instruments in active markets; and (3) the volatility of the
principal risk component of the financial instrument. For
certain portfolios of financial instruments that the Firm
manages on the basis of net open risk exposure, valuation
adjustments are necessary to reflect the cost of exiting a
larger-than-normal market-size net open risk position.
Where applied, such adjustments are based on factors
including the size of the adverse market move that is
likely to occur during the period required to reduce the
net open risk position to a normal market-size.
• Unobservable parameter valuation adjustments may be
made when positions are valued using internally
developed models that incorporate unobservable
parameters – that is, parameters that must be estimated
and are, therefore, subject to management judgment.
Unobservable parameter valuation adjustments are
applied to reflect the uncertainty inherent in the
valuation estimate provided by the model.
Where appropriate, the Firm also applies adjustments to its
estimates of fair value in order to appropriately reflect
counterparty credit quality and the Firm’s own
creditworthiness, applying a consistent framework across
the Firm. For more information on such adjustments see
Credit adjustments on page 212 of this Note
Valuation model review and approval
If prices or quotes are not available for an instrument or a
similar instrument, fair value is generally determined using
valuation models that consider relevant transaction data
such as maturity and use as inputs market-based or
independently sourced parameters. Where this is the case
the price verification process described above is applied to
the inputs to those models.
The Firm’s Model Risk function within the Firm’s Model Risk
and Development Group, which in turn reports to the Chief
Risk Officer, reviews and approves valuation models used by
the Firm. Model reviews consider a number of factors about
the model’s suitability for valuation of a particular product
including whether it accurately reflects the characteristics
and significant risks of a particular instrument; the selection
and reliability of model inputs; consistency with models for
similar products; the appropriateness of any model-related
adjustments; and sensitivity to input parameters and
assumptions that cannot be observed from the market.
When reviewing a model, the Model Risk function analyzes
and challenges the model methodology and the
reasonableness of model assumptions and may perform or
require additional testing, including back-testing of model
outcomes.
New significant valuation models, as well as material
changes to existing models, are reviewed and approved
prior to implementation except where specified conditions
are met. The Model Risk function performs an annual
Firmwide model risk assessment where developments in the
product or market are considered in determining whether
valuation models which have already been reviewed need to
be reviewed and approved again.
Valuation Hierarchy
A three-level valuation hierarchy has been established
under U.S. GAAP for disclosure of fair value measurements.
The valuation hierarchy is based on the transparency of
inputs to the valuation of an asset or liability as of the
measurement date. The three levels are defined as follows.
• Level 1 – inputs to the valuation methodology are quoted
prices (unadjusted) for identical assets or liabilities in
active markets.
• Level 2 – inputs to the valuation methodology include
quoted prices for similar assets and liabilities in active
markets, and inputs that are observable for the asset or
liability, either directly or indirectly, for substantially the
full term of the financial instrument.
• Level 3 – one or more inputs to the valuation
methodology are unobservable and significant to the fair
value measurement.
A financial instrument’s categorization within the valuation
hierarchy is based on the lowest level of input that is
significant to the fair value measurement.