Morgan Stanley 1999 Annual Report Download - page 51

page 49 |99 AR
and the purchase or sale of positions in related securities and finan-
cial instruments, including a variety of derivative products (e.g.,
swaps, options, futures and forwards). The Company manages the
market risk associated with its trading activities on a Company-wide
basis, on a trading division level worldwide and on an individual
product basis. The Company manages and monitors its market risk
exposures in such a way as to maintain a portfolio that the Company
believes is well-diversified with respect to market risk factors.
Market risk limits have been approved for the Company
and each major trading division of the Company worldwide (equity,
fixed income, foreign exchange and commodities). Discrete market
risk limits are assigned to trading desks and, as appropriate, prod-
ucts and regions. Trading division risk managers, desk risk man-
agers and the Firm Risk Management Department monitor market
risk measures against limits and report major market and position
events to senior management.
The Firm Risk Management Department independently
reviews the Company’s trading portfolios on a regular basis from a
market risk perspective utilizing Value-at-Risk and other quantitative
and qualitative risk measurements and analyses. The Company may
use measures, such as rate sensitivity, convexity, volatility and time
decay measurements, to estimate market risk and to assess the sen-
sitivity of positions to changes in market conditions. Stress testing,
which measures the impact on the value of existing portfolios of
specified changes in market factors, for certain products is per-
formed periodically and reviewed by trading division risk managers,
desk risk managers and the Firm Risk Management Department.
Value-at-Risk
The statistical technique known as Value-at-Risk (“VaR”) is one of
the tools used by management to measure, monitor and review the
market risk exposures of the Company’s trading portfolios. The Firm
Risk Management Department calculates and distributes daily VaR-
based risk measures to various levels of management.
VaR Methodology, Assumptions and Limitations
The Company estimates VaR using a model based on historical sim-
ulation for major market risk factors and Monte Carlo simulation for
name-specific risk in certain equity and fixed income exposures.
Historical simulation involves constructing a distribution of hypo-
thetical daily changes in trading portfolio value based on historical
observation of daily changes in key market indices or other market
factors (“market risk factors”) and on information on the sensitivity
of the portfolio values to these market risk factor changes. In the
case of the Company’s VaR, approximately four years of historical
data are used to characterize potential changes in market risk fac-
tors. The Company’s one-day 99% VaR corresponds to the negative
change in portfolio value that, based on observed market risk fac-
tor movements, would have been exceeded with a frequency of 1%,
or once in 100 trading days.
The VaR model generally takes into account linear and
non-linear exposures to price and interest rate risk and linear expo-
sure to implied volatility risks. Market risks that are incorporated in
the VaR model include equity and commodity prices, interest rates,
foreign exchange rates and associated volatilities. As of November
30, 1999, a total of approximately 500 market risk factor bench-
mark data series was incorporated in the Company’s VaR model
covering interest rates, equity prices, foreign exchange rates, com-
modity prices and associated volatilities. As a supplement to the
use of historical simulation for major market risk factors, the
Company’s VaR model uses Monte Carlo simulation to capture
name-specific risk in global equities and in U.S. corporate and
high-yield bonds. The model includes measures of name-specific
risk for approximately 8,000 equity names and 55 classes of cor-
porate and high-yield bonds.
VaR models such as the Company’s should be expected to
evolve over time in response to changes in the composition of trad-
ing portfolios and to improvements in modeling techniques and sys-
tems capabilities. During fiscal 1999, as part of the Company’s
ongoing program of VaR model enhancement, position and risk cov-
erage were broadened, and risk measurement methodologies were
refined. Equity enhancements included improved capture of name-
specific implied volatility risk for equity options of different matu-
rities, which tended to decrease measured VaR, and name-specific
equity price risk with respect to certain private equity positions,
which tended to increase VaR. Fixed income enhancements
included: improved modeling of implied volatility risk, improved
capture of interest rate related risks in mortgage-backed and
emerging market financial instruments, and a change, related to
EMU, from multiple to a single set of yield curve risk factors for
euro currencies, all of which tended to decrease measured VaR.
Among their benefits, VaR models permit estimation of a
portfolio’s aggregate market risk exposure, incorporating a range of
varied market risks; reflect risk reduction due to portfolio diversifi-