Morgan Stanley 1999 Annual Report Download - page 48

99 AR |page 46 have consistently operated in excess of their respective regulatory
requirements (see Note 11 to the consolidated financial statements).
Certain of the Company’s subsidiaries are Federal Deposit
Insurance Corporation (“FDIC”) insured financial institutions. Such
subsidiaries, therefore, are subject to the regulatory capital require-
ments adopted by the FDIC. These subsidiaries have consistently
operated in excess of these and other regulatory requirements.
Certain other U.S. and non-U.S. subsidiaries are subject to
various securities, commodities and banking regulations, and cap-
ital adequacy requirements promulgated by the regulatory and
exchange authorities of the countries in which they operate. These
subsidiaries have consistently operated in excess of their applica-
ble local capital adequacy requirements. In addition, Morgan
Stanley Derivative Products Inc., a triple-A rated subsidiary through
which the Company conducts some of its derivative activities, has
established certain operating restrictions which have been reviewed
by various rating agencies.
EFFECTS OF INFLATION AND CHANGES
IN FOREIGN EXCHANGE RATES
Because the Company’s assets to a large extent are liquid in nature,
they are not significantly affected by inflation. However, inflation
may result in increases in the Company’s expenses, which may not
be readily recoverable in the price of services offered. To the extent
inflation results in rising interest rates and has other adverse effects
upon the securities markets, upon the value of financial instruments
and upon the markets for consumer credit services, it may adversely
affect the Company’s financial position and profitability.
A portion of the Company’s business is conducted in cur-
rencies other than the U.S. dollar. Non-U.S. dollar assets typically
are financed by direct borrowing or swap-based funding in the same
currency. Changes in foreign exchange rates affect non-U.S. dollar
revenues as well as non-U.S. dollar expenses. Those foreign
exchange exposures that arise and are not hedged by an offsetting
foreign currency exposure are actively managed by the Company to
minimize risk of loss due to currency fluctuations.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company actively offers to clients and trades for its own
account a variety of financial instruments described as “derivative
products” or “derivatives.” These products generally take the form
of futures, forwards, options, swaps, caps, collars, floors, swap
options and similar instruments which derive their value from
underlying interest rates, foreign exchange rates, or commodity or
equity instruments and indices. All of the Company’s trading-
related divisions use derivative products as an integral part of their
respective trading strategies, and such products are used exten-
sively to manage the market exposure that results from a variety of
proprietary trading activities (see Note 9 to the consolidated finan-
cial statements). In addition, as a dealer in certain derivative prod-
ucts, most notably interest rate and currency swaps, the Company
enters into derivative contracts to meet a variety of risk manage-
ment and other financial needs of its clients. Given the highly inte-
grated nature of derivative products and related cash instruments
in the determination of overall trading division profitability and the
context in which the Company manages its trading areas, it is not
meaningful to allocate trading revenues between the derivative and
underlying cash instrument components. Moreover, the risks asso-
ciated with the Company’s derivative activities, including market
and credit risks, are managed on an integrated basis with associ-
ated cash instruments in a manner consistent with the Company’s
overall risk management policies and procedures (see “Risk
Management” following “Management’s Discussion and Analysis of
Financial Condition and Results of Operations”). It should be noted
that while particular risks may be associated with the use of deriv-
atives, in many cases derivatives serve to reduce, rather than
increase, the Company’s exposure to market, credit and other risks.
The total notional value of derivative trading contracts out-
standing at November 30, 1999 was $3,404 billion (as compared
with $2,860 billion at November 30, 1998). While these amounts
are an indication of the degree of the Company’s use of derivatives
for trading purposes, they do not represent the Company’s market or
credit exposure and may be more indicative of customer utilization
of derivatives. The Company’s exposure to market risk relates to
changes in interest rates, foreign currency exchange rates, or the fair
value of the underlying financial instruments or commodities. The
Company’s exposure to credit risk at any point in time is represented
by the fair value of such contracts reported as assets. Such total fair
value outstanding as of November 30, 1999 was $22.8 billion.
Approximately $18.4 billion of that credit risk exposure was with
counterparties rated single-A or better (see Note 9 to the consoli-
dated financial statements).
The Company also uses derivative products (primarily
interest rate, currency and equity swaps) to assist in asset and lia-