Goldman Sachs 2000 Annual Report Download - page 58

Risk Management
The firm seeks to monitor and control its risk exposure
through a variety of separate but complementary financial,
credit, operational and legal reporting systems.
Management believes that it has effective procedures for
evaluating and managing the market, credit and other risks
to which it is exposed. The Management Committee, the
firm’s primary decision-making body, determines (both
directly and through delegated authority) the types of busi-
ness in which the firm engages, approves guidelines for
accepting customers for all product lines, outlines the terms
under which customer business is conducted and estab-
lishes the parameters for the risks that the firm is willing to
undertake in its business.
The Firmwide Risk Committee, which reports to senior man-
agement and meets weekly, is responsible for managing and
monitoring all of the firm’s risk exposures. In addition, the
firm maintains segregation of duties, with credit review and
risk-monitoring functions performed by groups that are
independent from revenue-producing departments.
Market Risk. The potential for changes in the market value
of the firm’s trading positions is referred to as “market risk.”
The firm’s trading positions 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 currency
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.
These risk exposures are managed through diversification,
by controlling position sizes and by establishing hedges in
related securities or derivatives. For example, the firm may
hedge a portfolio of common stock by taking an offsetting
position in a related equity-index futures contract. The abil-
ity to manage these exposures 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 the related hedge instrument.
Credit Risk. Credit risk represents the loss that the firm
would incur if a counterparty or issuer of securities or other
instruments held by the firm fails to perform its contractual
obligations to the firm. To reduce credit exposures, the firm
seeks to enter into netting agreements with counterparties
that permit the firm to offset receivables and payables with
such counterparties. In addition, the firm attempts to further
reduce credit risk by entering into agreements that enable
us to obtain collateral from a counterparty, to terminate or
reset the terms of transactions after specified time periods
or upon the occurrence of credit-related events, by seeking
third-party guarantees of the counterparty’s obligations,
and through the use of credit derivatives.
Credit concentrations may arise from trading, underwriting
and securities borrowing activities and may be impacted by
changes in economic, industry or political factors. The firm’s
concentration of credit risk is monitored actively by the
Credit Policy Committee. As of November 2000 and 1999,
U.S. government and federal agency obligations repre-
sented 6% and 7%, respectively, of the firm’s total assets.
In addition, most of the firm’s securities purchased under
agreements to resell are collateralized by U.S. government,
federal agency and other sovereign obligations.
Derivative Activities
Most of the firm’s derivative transactions are entered into
for trading purposes. The firm uses derivatives in its trading
activities to facilitate customer transactions, to take propri-
etary positions and as a means of risk management. The firm
also enters into nontrading derivative contracts to manage
the interest rate and currency exposure on its long-term
borrowings. Nontrading derivatives related to the firm’s
long-term borrowings are discussed in Note 6.
Derivative contracts are financial instruments, such as
futures, forwards, swaps or option contracts, that derive
their value from underlying assets, indices, reference rates
or a combination of these factors. Derivatives may involve
future commitments to purchase or sell financial instruments
or commodities, or to exchange currency or interest pay-
56 Goldman Sachs Annual Report 2000