Morgan Stanley 2014 Annual Report Download - page 133

The Company’s VaR model generally takes into account linear and non-linear exposures to equity and
commodity price risk, interest rate risk, credit spread risk and foreign exchange rates. The model also takes into
account linear exposures to implied volatility risks for all asset classes and non-linear exposures to implied
volatility risks for equity, commodity and foreign exchange referenced products. The VaR model also captures
certain implied correlation risks associated with portfolio credit derivatives as well as certain basis risks (e.g.,
corporate debt and related credit derivatives).
The Company uses VaR as one of a range of risk management tools. Among their benefits, VaR models permit
estimation of a portfolio’s aggregate market risk exposure, incorporating a range of varied market risks and
portfolio assets. One key element of the VaR model is that it reflects risk reduction due to portfolio
diversification or hedging activities. However, VaR has various limitations, which include, but are not limited to:
use of historical changes in market risk factors, which may not be accurate predictors of future market conditions
and may not fully incorporate the risk of extreme market events that are outsized relative to observed historical
market behavior or reflect the historical distribution of results beyond the 95% confidence interval; and reporting
of losses in a single day, which does not reflect the risk of positions that cannot be liquidated or hedged in one
day. A small proportion of market risk generated by trading positions is not included in VaR. The modeling of
the risk characteristics of some positions relies on approximations that, under certain circumstances, could
produce significantly different results from those produced using more precise measures. 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. This
process also incorporates stress testing and scenario analyses and extensive risk monitoring, analysis and control
at the trading desk, division and Company levels.
The Company’s VaR model evolves 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 the Company’s regular process improvements,
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.
Since the reported VaR statistics are estimates based on historical data, VaR should not be viewed as predictive
of the Company’s future revenues or financial performance or of its ability to monitor and manage risk. There
can be no assurance that the Company’s actual losses on a particular day will not exceed the VaR amounts
indicated below or that such losses will not occur more than five times in 100 trading days for a 95%/one-day
VaR. VaR does not predict the magnitude of losses which, should they occur, may be significantly greater than
the VaR amount.
VaR statistics are not readily comparable across firms because of differences in the firms’ portfolios, modeling
assumptions and methodologies. These differences can result in materially different VaR estimates across firms
for similar portfolios. The impact of such differences varies depending on the factor history assumptions, the
frequency with which the factor history is updated and the confidence level. As a result, VaR statistics are more
useful when interpreted as indicators of trends in a firm’s risk profile rather than as an absolute measure of risk to
be compared across firms.
The Company utilizes the same VaR model for risk management purposes as well as for regulatory capital
calculations. The Company’s VaR model has been approved by the Company’s regulators for use in regulatory
capital calculations.
The portfolio of positions used for the Company’s Management VaR differs from that used for regulatory capital
requirements (“Regulatory VaR”), as Management VaR contains certain positions that are excluded from
Regulatory VaR. Examples include counterparty credit valuation adjustments and related hedges, as well as loans
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