Morgan Stanley 2009 Annual Report Download - page 96

non-public entities may include, but are not limited to, exposures to private equity, venture capital, private
partnerships, real estate funds and other funds. Such positions are less liquid, have longer investment horizons
and are more difficult to hedge than listed equities.
The Company is exposed to foreign exchange rate and implied volatility risk as a result of making markets in
foreign currencies and foreign currency derivatives, from maintaining foreign exchange positions and from holding
non-U.S. dollar-denominated financial instruments. The Company is exposed to commodity price and implied
volatility risk as a result of market-making activities and maintaining positions in physical commodities (such as
crude and refined oil products, natural gas, electricity, and precious and base metals) and related derivatives.
Commodity exposures are subject to periods of high price volatility as a result of changes in supply and demand.
These changes can be caused by weather conditions; physical production, transportation and storage issues; or
geopolitical and other events that affect the available supply and level of demand for these commodities.
The Company manages its trading positions by employing a variety of risk mitigation strategies. These strategies
include diversification of risk exposures and hedging. Hedging activities consist of the purchase or sale of
positions in related securities and financial instruments, including a variety of derivative products (e.g., futures,
forwards, swaps and options). Hedging activities may not always provide effective mitigation against trading
losses due to differences in the terms, specific characteristics or other basis risks that may exist between the
hedge instrument and the risk exposure that is being hedged. The Company manages the market risk associated
with its trading activities on a Company-wide basis, on a worldwide trading division level 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 in the aggregate with respect to market risk factors and
that reflects the Company’s aggregate risk tolerance as established by the Company’s senior management.
Aggregate market risk limits have been approved for the Company and for its major trading divisions worldwide
(equity and fixed income, which includes interest rate products, credit products, foreign exchange and
commodities). Additional market risk limits are assigned to trading desks and, as appropriate, products and
regions. Trading division risk managers, desk risk managers, traders and the Market Risk Department monitor
market risk measures against limits in accordance with policies set by senior management.
The Market Risk Department independently reviews the Company’s trading portfolios on a regular basis from a
market risk perspective utilizing VaR and other quantitative and qualitative risk measures and analyses. The
Company’s trading businesses and the Market Risk Department also use, as appropriate, measures such as
sensitivity to changes in interest rates, prices, implied volatilities and time decay to monitor and report market
risk exposures.
Net exposure, defined as the potential loss to the Company over a period of time in the event of default of a
referenced asset, assuming zero recovery, is one key risk measure the Company employs to standardize the
aggregation of market risk exposures across cash and derivative products. Stress testing, which measures the
impact on the value of existing portfolios of specified changes in market factors for certain products, is
performed periodically and is reviewed by trading division risk managers, desk risk managers and the Market
Risk Department.
VaR.The Company uses the statistical technique known as VaR as one of the tools used to measure, monitor and
review the market risk exposures of its trading portfolios. The Market Risk 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 simulation 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 hypothetical
daily changes in the value of trading portfolios based on two sets of inputs: historical observation of daily
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