Goldman Sachs 2001 Annual Report Download - page 42

page 40
GOLDMAN SACHS ANNUAL REPORT 2001
Categories of market risk include exposures to interest rates,
currency rates, equity prices and commodity prices. A descrip-
tion 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 prepayment 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 commodities,
such as electricity, natural gas, crude oil, petroleum products
and precious and base metals.
We seek to manage these risk exposures through diversifying
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 offsetting position in
a related equity-index futures contract. The ability to manage an
exposure may, however, be limited by adverse changes in the li-
quidity 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 management
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 poten-
tial effects on our trading net revenues of various market
events, including a large widening of credit spreads, a substan-
tial decline in equity markets and significant moves in emerg-
ing markets; and
• inventory position limits for selected business units and
country exposures.
We also estimate the broader potential impact of abnormal mar-
ket 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’ trad-
ing 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 horizon
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, shortfalls from expected trad-
ing 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 under-
lying 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 positions
involves a number of assumptions and approximations. While
management believes that these assumptions and approxima-
tions are reasonable, there is no uniform industry methodology
for estimating VaR, and different assumptions and/or approxi-
mations could produce materially different VaR estimates.
We use historical data to estimate our VaR and, to better reflect
current asset volatilities, we generally weight historical data to
give greater importance to more recent observations. Given its
reliance on historical data, VaR is most effective in estimating
risk exposures in markets in which there are no sudden funda-
mental changes or shifts in market conditions. An inherent limi-
tation of VaR is that the distribution of past changes in market
risk factors may not produce accurate predictions of future mar-
ket risk. Different VaR methodologies and distributional
assumptions could produce a materially different VaR.
Moreover, VaR calculated for a one-day time horizon does not
fully capture the market risk of positions that cannot be liqui-
dated or offset with hedges within one day.