Morgan Stanley 1999 Annual Report Download - page 76

99 AR |page 74 EQUITIES
The Company makes markets and trades in the global secondary
markets for equities and convertible debt and is a dealer in equity
warrants, exchange traded and OTC equity options, index futures,
equity swaps and other sophisticated equity derivatives. The
Company’s activities as a dealer primarily are client-driven, with the
objective of meeting clients’ needs while earning a spread between
the premiums paid or received on its contracts with clients and the
cost of hedging such transactions in the cash or forward market or
with other derivative transactions. The Company limits its market risk
related to these contracts, which stems primarily from underlying
equity/index price and volatility movements, by employing a variety
of hedging strategies, such as delta hedging (delta is a measure of a
derivative contract’s price movement based on the movement of the
price of the security or index underlying the contract). The Company
also takes proprietary positions in the global equity markets by using
derivatives, most commonly futures and options, in addition to cash
positions, intending to profit from market price and volatility move-
ments in the underlying equities or indices positioned.
Equity option contracts give the purchaser of the contract
the right to buy (call) or sell (put) the equity security or index
underlying the contract at an agreed-upon price (strike price) dur-
ing or at the conclusion of a specified period of time. The seller
(writer) of the contract is subject to market risk, and the purchaser
is subject to market risk (to the extent of the premium paid) and
credit risk. Equity swap contracts are contractual agreements
whereby one counterparty receives the appreciation (or pays the
depreciation) on an equity investment in return for paying another
rate, often based upon equity index movements or interest rates.
The counterparties to the Company’s equity transactions
include commercial banks, investment banks, broker-dealers,
investment funds and industrial companies.
FIXED INCOME
The Company is a market-maker for U.S. and non-U.S. government
securities, corporate bonds, money market instruments, medium-
term notes and Eurobonds, high-yield securities, emerging market
securities, mortgage- and other asset-backed securities, preferred
stock and tax-exempt securities. In addition, the Company is a
dealer in interest rate and currency swaps and other related deriv-
ative products, OTC options on U.S. and non-U.S. government
bonds and mortgage-backed forward agreements (“TBA”), options
and swaps. In this capacity, the Company facilitates asset and lia-
bility management for its customers in interest rate and currency
swaps and related products and OTC government bond options.
Swaps used in fixed income trading are, for the most part,
contractual agreements to exchange interest payment streams (i.e.,
an interest rate swap may involve exchanging fixed for floating
interest payments) or currencies (i.e., a currency swap may involve
exchanging yen for U.S. dollars in one year at an agreed-upon
exchange rate). The Company profits by earning a spread between
the premium paid or received for these contracts and the cost of
hedging such contracts. The Company seeks to manage the market
risk of its swap portfolio, which stems from interest rate and cur-
rency movements and volatility, by using modeling that quantifies
the sensitivity of its portfolio to movements in interest rates and
currencies and by adding positions to or selling positions from its
portfolio as needed to minimize such sensitivity. Typically, the
Company adjusts its positions by entering into additional swaps or
interest rate and foreign currency futures or foreign currency for-
wards and by purchasing or selling additional underlying govern-
ment bonds. The Company manages the risk related to its option
portfolio by using a variety of hedging strategies such as delta hedg-
ing, which includes the use of futures and forward contracts to
hedge market risk. The Company also is involved in using debt
securities to structure products with multiple risk/return factors
designed to suit investor objectives.
The Company is an underwriter of and a market-maker in
commercial and residential mortgage-backed securities and asset-
backed securities as well as commercial, residential and real estate
loan products. The Company provides financing to customers
for commercial, residential and real estate loan products. The
Company also uses TBA contracts in its role as a dealer in mortgage-
backed securities and facilitates customer trades by taking posi-
tions in the TBA market. Typically, these positions are hedged by
offsetting TBA contracts or underlying cash positions. The
Company profits by earning the bid-offer spread on such transac-
tions. As is the case with all mortgage-backed products, market risk
associated with these instruments results from interest rate fluctu-
ations and changes in mortgage prepayment speeds. The Company
also acts as principal and agent in aircraft finance transactions.
Acting as principal, the Company acquires aircraft outright or under