Goldman Sachs 2007 Annual Report Download - page 71

Management’s Discussion and Analysis
■ 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 equity markets and significant moves in selected emerging
markets; and
■ inventory position limits for selected business units.
VaR
VaR is the potential loss in value of 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 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 accumulate
over a longer time horizon such as a number of consecutive
trading days.
The modeling of the risk characteristics of our trading positions
involves a number of assumptions and approximations. While
management believes that these assumptions and approximations
are reasonable, there is no standard methodology for estimating
VaR, and different assumptions and/or approximations 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
fundamental changes or shifts in market conditions. An inherent
limitation of VaR is that the distribution of past changes in
market risk factors may not produce accurate predictions of
future market 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.
STRUCTURED PRODUCTS COMMITTEE. The Structured Products
Committee reviews and approves structured product transactions
entered into with our clients that raise legal, regulatory, tax or
accounting issues or present reputational risk to Goldman Sachs.
Market Risk
The potential for changes in the market value of our trading
and investing positions is referred to as market risk. Such
positions result from market-making, proprietary trading,
underwriting, specialist and investing activities. Substantially
all of our inventory positions are marked-to-market on a daily
basis and changes are recorded in net revenues.
Categories of market risk include exposures to interest rates,
equity prices, currency rates 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 prepayment speeds and
credit spreads.
■ Equity price risks result from exposures to changes in prices
and volatilities of individual equities, equity baskets and
equity indices.
■ Currency rate risks result from exposures to changes in spot
prices, forward prices and volatilities of currency rates.
■
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 risks by diversifying exposures,
controlling position sizes and establishing economic hedges in
related securities or derivatives. For example, we may hedge a
portfolio of common stocks 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 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 management
uses a number of quantitative tools to manage our exposure to
market risk for “Financial instruments owned, at fair value”
and “Financial instruments sold, but not yet purchased, at fair
value” in the consolidated statements of financial condition.
These tools include:
■ risk limits based on a summary measure of market risk
exposure referred to as VaR;
69Goldman Sachs 2007 Annual Report