Credit Portfolio

Case Brief

No more than 7 pages. Don't say more than you need to. Question-Answer is fine.

1) What was the synthetic credit portfolio? The Synthetic Credit Portfolio was the portfolio managed by CIO under Ina Drew that suffered large losses in 2012, composed of both long and short positions in instruments such as credit swap indices and related tranche instruments based on basket of credit default swaps tied to corporate debt issuer. The portfolio is supposed to offset the credit exposure from originating loans, but in reality, SCP trades different instruments to exploit pricing difference.

2) Would the synthetic credit portfolio have had both long and short positions if it was a hedge portfolio? If it were a true hedge portfolio to offset credit risk exposure, it should have only had one position whose grain went against the credit risk JP Morgan took on (i.e. long positions in CDS and tranch instrument that will provide credit protection.

3) What is RWA? Why does JPM care about RWA? Why did it want to reduce RWA in 2012? RWA are "risk-weighted assets". Not only is it important to understand what kind of and how much risk they want to take on, but JPM cares about RWA because the Basel III, which starts to take effect in 2013, imposed more strict requirement on Tier one capital ratios (4.5% from 2%)which is calculated by common equity over RWA. So in order to reduce the amount of capital JPM has to raise to meet the standard, it has to reduce RWA.

4) Why would market knowledge of the positions of the SCP make it harder to manage its risk? The review team formed under a senior member of Market Risk believed that market knowledge of the positions of the SCP would make it harder to reduce its risk because the public could take advantage of pricing and trading behavior. It's harder to reduce risk once the market knows that JPM's going to sell or buy its tranche instrument (which is like a bond with its coupon payment linked to interest payment on loan pool; a tranche decides the priority of payment, so the higher the tranche the safer the instrument, and lower yield), because the buyer or seller can reduce/raise the price to take advantage of it, especially when the trading amount is large.

5) What does it mean for the SCP portfolio to be balanced? "Balanced" means firstly protection from long positions in credit swap indices will cover the default payment to short SCP; secondly a balanced portfolio is supposed to be unaffected by credit yield movement when the yield of credit swap index has a high correlation with short SCP and therefore widening credit yield will benefit long position to cover the loss from short position.

6) What risk measures did JPM use for the SCP? The CIO used five key metrics and limits to gauge and control the risks including value-at-risk (VaR), Credit Spread Widening 01,Credit