Morgan Stanley 2014 Annual Report Download - page 132

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 commodity 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 Company’s 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 Company’s 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
volatility-adjusted historical simulation for general market risk factors and Monte Carlo simulation for name-
specific risk in corporate shares, bonds, loans and related derivatives. The model constructs a distribution of
hypothetical daily changes in the value of trading portfolios based on the following: 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
with a volatility adjustment to reflect current market conditions. The Company’s VaR for risk management
purposes (“Management VaR”) is computed at a 95% level of confidence over a one-day time horizon, which is a
useful indicator of possible trading losses resulting from adverse daily market moves. 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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