Goldman Sachs 2003 Annual Report Download - page 61

Management’s Discussion and Analysis
GOLDMAN SACHS 2003 ANNUAL REPORT 59
As part of our overall risk control process, daily trading net
revenues are compared with VaR calculated as of the end
of the prior business day. Trading losses incurred on a sin-
gle day did not exceed our 95% one-day VaR during 2003.
nontrading risk
The market risk for financial instruments in our non-
trading portfolio, including our merchant banking
investments but excluding our investment in the con-
vertible preferred stock of SMFG, is measured using a
sensitivity analysis that estimates the potential reduc-
tion in our net revenues associated with a 10% decline
in equity markets. This sensitivity analysis is based on
certain assumptions regarding the relationship between
changes in stock price indices and changes in the fair
value of the individual financial instruments in our non-
trading portfolio. Different assumptions could produce
materially different risk estimates. As of November
2003, the sensitivity of our nontrading portfolio
(excluding our investment in the convertible preferred
stock of SMFG) to a 10% equity market decline was
$104 million compared with $80 million as of
November 2002, primarily reflecting an increase in the
carrying value of the portfolio.
The market risk of our investment in the convertible pre-
ferred stock of SMFG is measured using a sensitivity
analysis that estimates the potential reduction in our net
revenues associated with a 10% decline in the SMFG
common stock price. As of November 2003, the sensitiv-
ity of our investment to a 10% decline in the SMFG
common stock price was $75 million. This sensitivity
should not be extrapolated to other movements in the
SMFG common stock price, as the relationship between
the fair value of our investment and the SMFG common
stock price is nonlinear.
Credit Risk
Credit risk represents the loss that we would incur if a
counterparty or an issuer of securities or other instru-
ments we hold, fails to perform under its contractual
obligations to us. To reduce our credit exposures, we seek
to enter into netting agreements with counterparties that
permit us to offset receivables and payables with such
counterparties. In addition, we attempt to further reduce
credit risk with certain counterparties by entering into
agreements that enable us to obtain collateral from a
counterparty or to terminate or reset the terms of transac-
tions 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 and other structures and techniques.
For most businesses, counterparty credit limits are estab-
lished by the Credit Department, which is independent of
the revenue-producing departments, based on guidelines
set by the Firmwide Risk Committee and the Credit
Policy Committee. For most products, we measure and
limit credit exposures by reference to both current and
potential exposure. We typically measure potential expo-
sure based on projected worst-case market movements
over the life of a transaction within a 95% confidence
interval. For collateralized transactions we also evaluate
potential exposure over a shorter collection period, and
give effect to the value of collateral received. We further
seek to measure credit exposure through the use of sce-
nario analyses, stress tests and other quantitative tools.
Our global credit management systems monitor current
and potential credit exposure to individual counterparties
and on an aggregate basis to counterparties and their
affiliates. The systems also provide management, includ-
ing the Firmwide Risk and Credit Policy Committees,
with information regarding overall credit risk by product,
industry sector, country and region.
As of both November 2003 and November 2002, we
held U.S. government and federal agency obligations that
represented 6% of our total assets. In addition, most of
our securities purchased under agreements to resell are
collateralized by U.S. government, federal agency and
other sovereign obligations. As of November 2003 and
November 2002, we did not have credit exposure to any
other counterparty that exceeded 5% of our total assets.
However, over the past several years, the amount and
duration of our credit exposures have been increasing,
due to, among other factors, the growth of our lending
and OTC derivatives activities. A further discussion of
our derivative activities follows below.
Derivatives
Derivative contracts are 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. Derivative instruments
may be privately negotiated contracts, which are often
referred to as OTC derivatives, or they may be listed and
traded on an exchange.
Most of our derivative transactions are entered into for
trading purposes. We use derivatives in our trading activ-
ities to facilitate customer transactions, to take propri-
etary positions and as a means of risk management. We
also enter into derivative contracts to manage the inter-
est rate, currency and equity-linked exposure on our
long-term borrowings.
Derivatives are used in many of our businesses, and
we believe that the associated market risk can only be
understood relative to the underlying assets or risks
being hedged, or as part of a broader trading strategy.