Morgan Stanley 2009 Annual Report Download - page 97

changes in key market indices or other market factors (“market risk factors”); and information on the sensitivity
of the portfolio values to these market risk factor changes. The Company’s VaR model uses four years of
historical data to characterize potential changes in market risk factors. The Company’s 95%/one-day VaR
corresponds to the unrealized loss in portfolio value that, based on historically observed market risk factor
movements, would have been exceeded with a frequency of 5%, or five times in every 100 trading days, if the
portfolio were held constant for one day.
The Company’s VaR model generally takes into account linear and non-linear exposures to price risk, interest
rate risk and credit spread risk and linear exposures to implied volatility risks. Market risks that are incorporated
in the VaR model include equity and commodity prices, interest rates, credit spreads, foreign exchange rates and
associated implied volatilities. The VaR model also captures certain correlation risks associated with portfolio
credit derivatives, as well as certain basis risks between corporate debt and related credit derivatives. 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 equities and credit products (i.e., corporate bonds, loans
and credit derivatives).
The Company’s VaR models evolve over time in response to changes in the composition of trading portfolios
and to improvements in modeling techniques and systems capabilities. The Company is committed to continuous
review and enhancement of VaR methodologies and assumptions in order to capture evolving risks associated
with changes in market structure and dynamics. As part of regular process improvement, additional systematic
and name-specific risk factors may be added to improve the VaR model’s ability to more accurately estimate
risks to specific asset classes or industry sectors.
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 diversification or hedging
activities; and can cover a wide range of portfolio assets. However, VaR risk measures should be interpreted
carefully in light of the methodology’s limitations, which include the following: past changes in market risk
factors may not always yield accurate predictions of the distributions and correlations of future market
movements; changes in portfolio value in response to market movements (especially for complex derivative
portfolios) may differ from the responses calculated by a VaR model; VaR using a one-day time horizon does not
fully capture the market risk of positions that cannot be liquidated or hedged within one day; the historical
market risk factor data used for VaR estimation may provide only limited insight into losses that could be
incurred under market conditions that are unusual relative to the historical period used in estimating the VaR; and
published VaR results reflect past trading positions while future risk depends on future positions. VaR is most
appropriate as a risk measure for trading positions in liquid financial markets and will understate the risk
associated with severe events, such as periods of extreme illiquidity. The Company is aware of these and other
limitations and, therefore, uses VaR as only one component in its risk management oversight process. As
explained above, this process also incorporates stress testing and scenario analyses and extensive risk monitoring,
analysis, and control at the trading desk, division and Company levels.
VaR for 2009.The table below presents the Company’s Trading, Non-trading and Aggregate VaR for each of
the Company’s primary market risk exposures as of December 31, 2009, December 31, 2008 and November 30,
2008, incorporating substantially all financial instruments generating market risk that are managed by the
Company’s trading businesses. This measure of VaR incorporates most of the Company’s trading-related market
risks. However, a small proportion of trading positions generating market risk is not included in VaR, and the
modeling of the risk characteristics of some positions relies upon approximations that, under certain
circumstances, could produce significantly different VaR results from those produced using more precise
measures.
Aggregate VaR also incorporates certain non-trading risks, including (a) the interest rate risk generated by
funding liabilities related to institutional trading positions, (b) public company equity positions recorded as
investments by the Company and (c) corporate loan exposures that are awaiting distribution to the market.
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