Goldman Sachs 2000 Annual Report Download - page 42

Market Risk
The potential for changes in the market value of our trading
positions is referred to as “market risk.” Our trading posi-
tions result from underwriting, market making, specialist
and proprietary trading activities.
Categories of market risk include exposures to interest
rates, currency rates, equity prices and commodity prices. A
description of each market risk category is set forth below:
• Interest rate risks primarily result from exposures to
changes in the level, slope and curvature of the yield
curve, the volatility of interest rates, mortgage prepay-
ment speeds and credit spreads.
• Currency rate risks result from exposures to changes
in spot prices, forward prices and volatilities of cur-
rency rates.
• Equity price risks result from exposures to changes in
prices and volatilities of individual equities, equity
baskets and equity indices.
• Commodity price risks result from exposures to changes
in spot prices, forward prices and volatilities of com-
modities, such as electricity, natural gas, crude oil,
petroleum products and precious and base metals.
We seek to manage these risk exposures through diversify-
ing exposures, controlling position sizes and establishing
hedges in related securities or derivatives. For example, we
may hedge a portfolio of common stock by taking an offset-
ting position in a related equity-index futures contract. The
ability to manage an exposure may, however, be limited by
adverse changes in the liquidity of the security or the related
hedge instrument and in the correlation of price movements
between the security and related hedge instrument.
In addition to applying business judgment, senior manage-
ment uses a number of quantitative tools to manage our
exposure to market risk. These tools include:
• risk limits based on a summary measure of market risk
exposure referred to as VaR;
• risk limits based on scenario analyses that measure the
potential effects on our trading net revenues of various
market events, including a large widening of credit
spreads, a substantial decline in equity markets and
significant moves in emerging markets; and
• inventory position limits for selected business units
and country exposures.
We also estimate the broader potential impact of abnormal
market movements and certain macroeconomic scenarios
on our investment banking, merchant banking, asset
management and security services activities as well as our
trading revenues.
VaR. VaR is the potential loss in value of Goldman Sachs’
trading positions due to adverse market movements over a
defined time horizon with a specified confidence level.
For the VaR numbers reported below, a one-day time hori-
zon and a 95% confidence level were used. This means that
there is a one in 20 chance that daily trading net revenues
will fall below the expected daily trading net revenues by an
amount at least as large as the reported VaR. Thus, short-
falls from expected trading net revenues on a single trading
day greater than the reported VaR would be anticipated
to occur, on average, about once a month. Shortfalls on a
single day can exceed reported VaR by significant amounts.
Shortfalls can also accumulate over a longer time horizon
such as a number of consecutive trading days.
The VaR numbers below are shown separately for interest
rate, currency, equity and commodity products, as well as
for our overall trading positions. These VaR numbers
include the underlying product positions and related
hedges, which may include positions in other product areas.
For example, the hedge of a foreign exchange forward may
include an interest rate futures position and the hedge of a
long corporate bond position may include a short position in
the related equity.
The modeling of the risk characteristics of our trading posi-
tions involves a number of assumptions and approxima-
tions. While management believes that these assumptions
and approximations are reasonable, there is no uniform
industry methodology for estimating VaR, and different
assumptions and/or approximations could produce materi-
ally different VaR estimates.
We use historical data to estimate our VaR and, to better
reflect current asset volatilities, these historical data are
weighted to give greater importance to more recent obser-
vations. Given its reliance on historical data, VaR is most
effective in estimating risk exposures in markets in which
there are no sudden fundamental changes or shifts in mar-
40 Goldman Sachs Annual Report 2000