JP Morgan Chase 2013 Annual Report Download - page 190

Notes to consolidated financial statements
196 JPMorgan Chase & Co./2013 Annual Report
The valuation control function determines any valuation
adjustments that may be required to the estimates provided
by the risk-taking functions. No adjustments are applied to
the quoted market price for instruments classified within
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
that may be 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 quotes or alternatively
pricing points for similar instruments in active markets;
and (3) the volatility of the principal risk component of
the financial instrument.
The Firm manages certain portfolios of financial
instruments on the basis of net open risk exposure and,
as permitted by US GAAP, has elected to estimate the
fair value of such portfolios on the basis of a transfer of
the entire net open risk position in an orderly
transaction. Where this is the case, valuation
adjustments may be 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 that a relevant market participant would
consider in the transfer of the net open risk position
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
Impact of funding on valuation estimates
The Firm incorporates the impact of funding in its valuation
estimates where there is evidence that a market participant
in the principal market would incorporate it in a transfer of
the instrument. As a result, the fair value of collateralized
derivatives is estimated by discounting expected future cash
flows at the relevant overnight indexed swap (“OIS”) rate
given the underlying collateral agreement with the
counterparty. Prior to the fourth quarter of 2013, the Firm
did not incorporate the impact of funding in its valuation of
uncollateralized (including partially collateralized)
derivatives and structured notes. However, during the
fourth quarter of 2013, the Firm implemented a funding
valuation adjustment (“FVA”) framework to incorporate its
best estimate of the funding cost or benefit that a relevant
market participant would consider in the transfer of an OTC
derivative or structured note. As a result, the Firm recorded
a one time $1.5 billion loss in principal transactions
revenue in the fourth quarter, which was recorded in the
CIB.
The FVA framework applies to both assets and liabilities, but
the adjustment in the fourth quarter largely relates to
uncollateralized derivative receivables given that the impact
of the Firm’s own credit risk, which is a significant
component of funding costs, is already incorporated in the
valuation of liabilities through the application of DVA.
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.