The Outline of JP Morgan's Strategic Tactics and Progression

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Background of JP Morgan

J.P. Morgan, a commercial banking giant headquartered in New York, USA, is one of the largest financial services organizations in the United States with operations in more than 50 countries. JP Morgan's Chief Investment Office (CIO) - the official function is to manage the risk hedging of the credit portfolio, such as interest rates, exchange rates and other risks. On May 13, 2012, JP Morgan CEO announced that due to the huge exposure of the CIO and the trading strategy mistakes, the bank lost about $2 billion in the past month, the future loss may further expand, and in the end of 2012 the total loss hit with $6.2 billion.The transaction loss event triggered the regulator to impose stricter supervision on the bank's high-risk proprietary trading.

Risk Management of JP Morgan

JP Morgan’s debt was around $1.1 trillion, more than $750 billion in loan assets. So, JP Morgan Chase used the excess deposits to invest. JP Morgan’s investments are concentrated on high-rated, low-risk securities. Through CIO, JP Morgan Chase manages the hedging of basis risk, convexity risk and exchange rate risk, and holds hedging exposure to manage the “stress-loss” risk of credit portfolios. In conclusion, JP Morgan bought a lot of securities and needed the CIO department to use derivatives to hedge the risks.

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What Went Wrong?

This huge loss happened to the CIO's Synthetic Credit Portfolio (SCP). Its role is to hedge the CIO's investment and the risk of the entire JP Morgan Chase as a lender. Usually this portfolio holds credit derivatives, including various CDS, CDS indices, and CDS stratification indices. The beginning of the matter is that JP Morgan Chase wants to use Basel III. In order to meet regulatory requirements, banks need to reduce the RWA (risk-weighted assets) of the entire company. The SCP is a large RWA occupant. At the end of 2011, the company decided to reduce the RWA resources occupied by the SCP. CIO trader Ikers believes that selling more credit protection is a way, but it will increase the volatility of the portfolio profit and loss, so that the portfolio breaks the stress test limit. So, the CIO conducts a curve trade, specifically the Flattener strategy, which is a strategy of betting that the curve will flatten, selling a long-term CDS index (CDX) and buying a short-term CDS index.

The upward sloping curve indicates that the default risk of long-term corporate bonds is higher than that of short-term corporate bonds. JPMorgan’s strategy is to gamble that the curve will flatten, shorting the 10-year CDX.NA. IG9 index contract and the five-year CDX.NA. IG9 index contract. The strategy needs to maintain the ratio between the purchase of the short-term contract of the CDS index term curve and the long-term contract. Because JP Morgan Chase's hedging position was huge, this strategy means that once the hedge was wrong, its exposure would become highly risky and volatile. Due to the massive sale of the 10-year CDX index by JP Morgan Chase, the corresponding CDX contract was seriously undervalued which means that the market had a lot of arbitrage opportunities. Because the derivatives market was illiquid, such a large position makes it easy for the opponent to guess the position and the purpose of the transaction. And because the size of the deal is too large, the market price becomes too cheap compared to the fair price. This has made SCP's position a huge loss in accordance with market value. Since the beginning of April 2012, the credit spread at the far end of the curve rose due to the weaker-than-expected US employment and retail sales data and the contagion of the European debt crisis, resulting in further losses of the long CDX exposure of SCP at long term.

Alternative RM Techniques

This CIO event shows many flaws in risk management. CIO should have a chief risk officer to observe and report risk. The actual risk management function relies on the CIO head Drew. However, Drew has several positions and is not really responsible. At the same time, her position of making profit also has conflicts of interest with risk management. In addition, the CIO should have much more detailed risk limits are not only for the CIO department as a whole, but for each portfolio, especially the SCP.

Experience from JP Morgan

From the internal environment, top investment banks’ power and responsibility allocation should be separated, and the organizational structure usually needs to be improved. For the RM purpose, there should be indicators on scale, asset type, risk factor, and specific indicators for SCP's trading strategy. Which would result in SCP's trading strategy being managed in a targeted manner in the future.

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