JP Morgan Chase 2015 Annual Report Download - page 138

Management’s discussion and analysis
128 JPMorgan Chase & Co./2015 Annual Report
In addition to the collateral described in the preceding
paragraph, the Firm also holds additional collateral
(primarily cash; G7 government securities; other liquid
government-agency and guaranteed securities; and
corporate debt and equity securities) 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. Although 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,
2015 and 2014, the Firm held $43.7 billion and $48.6
billion, respectively, of this additional collateral. The
derivative receivables fair value, 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.
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 represents a conservative measure of potential
exposure to a counterparty calculated in a manner that is
broadly equivalent to a 97.5% confidence level. Peak is the
primary measure used by the Firm for setting of credit
limits for derivative transactions, senior management
reporting and derivatives exposure management. 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. DRE is a less extreme measure of potential
credit loss than Peak and is used for aggregating derivative
credit risk exposures with loans and other credit risk.
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 $32.4 billion and $37.5 billion at
December 31, 2015 and 2014, respectively, compared with
derivative receivables, net of all collateral, of $43.1 billion
and $59.4 billion at December 31, 2015 and 2014,
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 the
Firm’s current derivatives portfolio over the next 10 years
as calculated by the Peak, DRE and AVG metrics. The three
measures generally show that exposure will decline after
the first year, if no new trades are added to the portfolio.
Exposure profile of derivatives measures
December 31, 2015
(in billions)