JP Morgan Chase 2012 Annual Report Download - page 194

Notes to consolidated financial statements
204 JPMorgan Chase & Co./2012 Annual Report
Level 3 valuations
The Firm has established well-documented processes for
determining fair value, including for instruments where
fair value is estimated using significant unobservable
inputs (level 3). For further information on the Firm’s
valuation process and a detailed discussion of the
determination of fair value for individual financial
instruments, see pages 196–200 of this Note.
Estimating fair value requires the application of judgment.
The type and level of judgment required is largely
dependent on the amount of observable market
information available to the Firm. For instruments valued
using internally developed models that use significant
unobservable inputs and are therefore classified within
level 3 of the fair value hierarchy, judgments used to
estimate fair value are more significant than those
required when estimating the fair value of instruments
classified within levels 1 and 2.
In arriving at an estimate of fair value for an instrument
within level 3, management must first determine the
appropriate model to use. Second, due to the lack of
observability of significant inputs, management must
assess all relevant empirical data in deriving valuation
inputs — including, but not limited to, transaction details,
yield curves, interest rates, prepayment speed, default
rates, volatilities, correlations, equity or debt prices,
valuations of comparable instruments, foreign exchange
rates and credit curves. Finally, management judgment
must be applied to assess the appropriate level of
valuation adjustments to reflect counterparty credit
quality, the Firm’s creditworthiness, constraints on
liquidity and unobservable parameters, where relevant.
The judgments made are typically affected by the type of
product and its specific contractual terms, and the level of
liquidity for the product or within the market as a whole.
The following table presents the Firm’s primary level 3
financial instruments, the valuation techniques used to
measure the fair value of those financial instruments, the
significant unobservable inputs, the range of values for
those inputs and the weighted averages of such inputs.
While the determination to classify an instrument within
level 3 is based on the significance of the unobservable
inputs to the overall fair value measurement, level 3
financial instruments typically include observable
components (that is, components that are actively quoted
and can be validated to external sources) in addition to the
unobservable components. The level 1 and/or level 2
inputs are not included in the table. In addition, the Firm
manages the risk of the observable components of level 3
financial instruments using securities and derivative
positions that are classified within levels 1 or 2 of the fair
value hierarchy.
The range of values presented in the table is
representative of the highest and lowest level input used
to value the significant groups of instruments within a
product/instrument classification. The input range does
not reflect the level of input uncertainty, instead it is
driven by the different underlying characteristics of the
various instruments within the classification. For example,
two option contracts may have similar levels of market risk
exposure and valuation uncertainty, but may have
significantly different implied volatility levels because the
option contracts have different underlyings, tenors , or
strike prices.
Where provided, the weighted averages of the input values
presented in the table are calculated based on the fair
value of the instruments that the input is being used to
value. In the Firm’s view, the input range and the weighted
average value do not reflect the degree of input
uncertainty or an assessment of the reasonableness of the
Firm’s estimates and assumptions. Rather, they reflect the
characteristics of the various instruments held by the Firm
and the relative distribution of instruments within the
range of characteristics. The input range and weighted
average values will therefore vary from period to period
and parameter to parameter based on the characteristics
of the instruments held by the Firm at each balance sheet
date.