JPMORGAN CHASE WHALE TRADES: A CASE HISTORY OF DERIVATIVES RISKS AND ABUSES

A. Background
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(1) Valuing Derivatives In General
Under U.S. Generally Accepted Accounting Principles (GAAP), at the close of every
business day, companies that own derivatives, including credit derivatives, must establish their
“fair value.” 606 Under GAAP, fair value is defined as “the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.” 607
GAAP explains that deriving fair value “assumes a hypothetical
transaction but is nonetheless a market-driven exercise using the best available information at
hand.”
GAAP specifies a hierarchy of three categories of information that should be used when
calculating the fair value of a derivative, placing a priority on observed market prices. 608 Level 1
consists of “quoted prices in active markets for identical assets or liabilities.” 609 Level 2 consists
of “inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly.” 610 They include, for example, quoted prices for similar
assets in either active or inactive markets. Level 3 consists of “unobservable inputs,” such as
pricing models used when no actual market prices are available. 611
To establish the fair value of a derivative that is traded in a dealer’s market, such as credit
derivatives, GAAP focuses on the prices actually used by the dealers. Since those prices
fluctuate over the course of the day, a key issue is what price to use within the daily range of
prices being offered in the marketplace. The daily price range is often referred to as the “bid-ask
spread,” meaning the prices that dealers offer to buy or sell a derivative during the course of a
trading day. GAAP states: “[T]he price within the bid-ask spread that is most representative of
fair value in the circumstances shall be used to measure fair value.” 612
Determining what price within a given price range is “most representative of fair value in
the circumstances” permits market participants to exercise a degree of subjective judgment.
GAAP also supports using “mid-market pricing … as a practical expedient for fair value
measurements within a bid-ask spread.” 613
By “mid-market pricing,” it means the price in the
middle of the day’s price range. For that reason, many market participants routinely use the
midpoint price of a derivative’s bid-ask spread in their daily financial reporting. To supply that
information, some firms that administer credit indices publish or provide clients with the daily
606
Accounting Standards Codification Topic 820-10-30, Fair Value Measurements and Disclosures (ASC 820).
607
Id.
608
Accounting Standards Codification Topic 820-10-35-37, Fair Value Measurements and Disclosures (ASC 820).
609
Accounting Standards Codification Topic 820-10-35-40, Fair Value Measurements and Disclosures (ASC 820).
610
Accounting Standards Codification Topic 820-10-35-47, Fair Value Measurements and Disclosures (ASC 820).
611
Accounting Standards Codification Topic 820-10-35-52, Fair Value Measurements and Disclosures (ASC 820).
612
Accounting Standards Codification Topic 820-10-35-36C, Fair Value Measurements and Disclosures (ASC
820).
613
Accounting Standards Codification Topic 820-10-35-36D, Fair Value Measurements and Disclosures (ASC
820).