Goldman Sachs 2003 Annual Report Download - page 58

Management’s Discussion and Analysis
56 GOLDMAN SACHS 2003 ANNUAL REPORT
We seek to manage these risks through diversifying expo-
sures, 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 posi-
tion 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 man-
agement 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;
•scenario analyses, stress tests and other analytical
tools that measure the potential effects on our
trading net revenues of various market events,
including, but not limited to, a large widening of
credit spreads, a substantial decline in equities
markets and significant moves in selected emerg-
ing markets; and
•inventory position limits for selected business units.
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 1 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 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 accumu-
late over a longer time horizon such as a number of con-
secutive trading days.
The VaR numbers below are shown separately for inter-
est rate, equity, currency and commodity products, as
well as for our overall trading positions. These VaR num-
bers include the underlying product positions and related
hedges that 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 approx-
imations. While management believes that these assump-
tions and approximations are reasonable, there is no
uniform industry methodology for estimating VaR, and
different assumptions and/or approximations could pro-
duce materially different VaR estimates.
We use historical data to estimate our VaR and, to better
reflect current asset volatilities, we generally weight his-
torical 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 fundamental changes or shifts
in market conditions. An inherent limitation of VaR is
that the distribution of past changes in market risk fac-
tors 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 liquidated or offset with hedges within one
day. Changes in VaR between reporting periods are gen-
erally due to changes in levels of exposure, volatilities
and/or correlations among asset classes.