Morgan Stanley 2009 Annual Report Download - page 185

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
The Company also enters into index and basket credit default swaps where the credit protection provided is based
upon the application of tranching techniques. In tranched transactions, the credit risk of an index or basket is
separated into various portions of the capital structure, with different levels of subordination. The most junior
tranches cover initial defaults, and once losses exceed the notional of the tranche, they are passed on to the next
most senior tranche in the capital structure. As external credit ratings are not always available for tranched
indices and baskets, credit ratings were determined based upon an internal methodology.
Credit Protection Sold Through CLNs. The Company has invested in CLNs, which are hybrid instruments
containing embedded derivatives, in which credit protection has been sold to the issuer of the note. If there is a
credit event of a reference entity underlying the CLN, the principal balance of the note may not be repaid in full
to the Company.
Purchased Credit Protection. For single name credit default swaps and non-tranched index and basket credit
default swaps, the Company has purchased protection with a notional amount of approximately $1.9 trillion and
$2.7 trillion as of December 31, 2009 and December 31, 2008, respectively, compared with a notional amount of
approximately $2.1 trillion and $3.0 trillion, as of December 31, 2009 and December 31, 2008, respectively, of
credit protection sold with identical underlying reference obligations. In order to identify purchased protection
with the same underlying reference obligations, the notional amount for individual reference obligations within
non-tranched indices and baskets was determined on a pro rata basis and matched off against single name and
non-tranched index and basket credit default swaps where credit protection was sold with identical underlying
reference obligations. The Company may also purchase credit protection to economically hedge loans and
lending commitments. In total, not considering whether the underlying reference obligations are identical, the
Company has purchased credit protection of $2.5 trillion with a positive fair value of $65 billion compared with
$2.4 trillion of credit protection sold with a negative fair value of $44 billion as of December 31, 2009. In total,
not considering whether the underlying reference obligations are identical, the Company has purchased credit
protection of $3.7 trillion with a positive fair value of $458 billion compared with $3.6 trillion of credit
protection sold with a negative fair value of $430 billion as of December 31, 2008.
The purchase of credit protection does not represent the sole manner in which the Company risk manages its
exposure to credit derivatives. The Company manages its exposure to these derivative contracts through a variety
of risk mitigation strategies, which include managing the credit and correlation risk across single name,
non-tranched indices and baskets, tranched indices and baskets, and cash positions. Aggregate market risk limits
have been established for credit derivatives, and market risk measures are routinely monitored against these
limits. The Company may also recover amounts on the underlying reference obligation delivered to the Company
under credit default swaps where credit protection was sold.
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