JP Morgan Chase 2015 Annual Report Download - page 229

JPMorgan Chase & Co./2015 Annual Report 219
Credit derivatives
Credit derivatives are financial instruments whose value is
derived from the credit risk associated with the debt of a
third-party issuer (the reference entity) and which allow
one party (the protection purchaser) to transfer that risk to
another party (the protection seller). Credit derivatives
expose the protection purchaser to the creditworthiness of
the protection seller, as the protection seller is required to
make payments under the contract when the reference
entity experiences a credit event, such as a bankruptcy, a
failure to pay its obligation or a restructuring. The seller of
credit protection receives a premium for providing
protection but has the risk that the underlying instrument
referenced in the contract will be subject to a credit event.
The Firm is both a purchaser and seller of protection in the
credit derivatives market and uses these derivatives for two
primary purposes. First, in its capacity as a market-maker,
the Firm actively manages a portfolio of credit derivatives
by purchasing and selling credit protection, predominantly
on corporate debt obligations, to meet the needs of
customers. Second, as an end-user, the Firm uses credit
derivatives to manage credit risk associated with lending
exposures (loans and unfunded commitments) and
derivatives counterparty exposures in the Firm’s wholesale
businesses, and to manage the credit risk arising from
certain financial instruments in the Firm’s market-making
businesses. Following is a summary of various types of
credit derivatives.
Credit default swaps
Credit derivatives may reference the credit of either a single
reference entity (“single-name”) or a broad-based index.
The Firm purchases and sells protection on both single-
name and index-reference obligations. Single-name CDS and
index CDS contracts are either OTC or OTC-cleared
derivative contracts. Single-name CDS are used to manage
the default risk of a single reference entity, while index CDS
contracts are used to manage the credit risk associated with
the broader credit markets or credit market segments. Like
the S&P 500 and other market indices, a CDS index consists
of a portfolio of CDS across many reference entities. New
series of CDS indices are periodically established with a new
underlying portfolio of reference entities to reflect changes
in the credit markets. If one of the reference entities in the
index experiences a credit event, then the reference entity
that defaulted is removed from the index. CDS can also be
referenced against specific portfolios of reference names or
against customized exposure levels based on specific client
demands: for example, to provide protection against the
first $1 million of realized credit losses in a $10 million
portfolio of exposure. Such structures are commonly known
as tranche CDS.
For both single-name CDS contracts and index CDS
contracts, upon the occurrence of a credit event, under the
terms of a CDS contract neither party to the CDS contract
has recourse to the reference entity. The protection
purchaser has recourse to the protection seller for the
difference between the face value of the CDS contract and
the fair value of the reference obligation at settlement of
the credit derivative contract, also known as the recovery
value. The protection purchaser does not need to hold the
debt instrument of the underlying reference entity in order
to receive amounts due under the CDS contract when a
credit event occurs.
Credit-related notes
A credit-related note is a funded credit derivative where the
issuer of the credit-related note purchases from the note
investor credit protection on a reference entity or an index.
Under the contract, the investor pays the issuer the par
value of the note at the inception of the transaction, and in
return, the issuer pays periodic payments to the investor,
based on the credit risk of the referenced entity. The issuer
also repays the investor the par value of the note at
maturity unless the reference entity (or one of the entities
that makes up a reference index) experiences a specified
credit event. If a credit event occurs, the issuer is not
obligated to repay the par value of the note, but rather, the
issuer pays the investor the difference between the par
value of the note and the fair value of the defaulted
reference obligation at the time of settlement. Neither party
to the credit-related note has recourse to the defaulting
reference entity.
The following tables present a summary of the notional
amounts of credit derivatives and credit-related notes the
Firm sold and purchased as of December 31, 2015 and
2014. Upon a credit event, the Firm as a seller of protection
would typically pay out only a percentage of the full
notional amount of net protection sold, as the amount
actually required to be paid on the contracts takes into
account the recovery value of the reference obligation at
the time of settlement. The Firm manages the credit risk on
contracts to sell protection by purchasing protection with
identical or similar underlying reference entities. Other
purchased protection referenced in the following tables
includes credit derivatives bought on related, but not
identical, reference positions (including indices, portfolio
coverage and other reference points) as well as protection
purchased through credit-related notes.