Morgan Stanley 2010 Annual Report Download - page 105

The activities from which those exposures arise and the markets in which the Company is active include, but are
not limited to, the following: corporate and government debt across both developed and emerging markets and
asset-backed debt (including mortgage-related securities).
The Company is exposed to equity price and implied volatility risk as a result of making markets in equity
securities and derivatives and maintaining other positions (including positions in non-public entities). Positions in
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 across all divisions worldwide. 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.
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
corporate shares, bonds, loans and related derivatives. 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 changes in key market indices or other 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.
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