Morgan Stanley 2014 Annual Report Download - page 252

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
The Company also enters into index and basket credit default swaps where the credit protection provided is based
upon the application of tranching techniques. In tranched transactions, the credit risk of an index or basket is
separated into various portions of the capital structure, with different levels of subordination. The most junior
tranches cover initial defaults, and once losses exceed the notional of the tranche, they are passed on to the next
most senior tranche in the capital structure.
When external credit ratings are not available, credit ratings are determined based upon an internal methodology.
Credit Protection Sold through CLNs and CDOs. The Company has invested in CLNs and CDOs, which are
hybrid instruments containing embedded derivatives, in which credit protection has been sold to the issuer of the
note. If there is a credit event of a reference entity underlying the instrument, the principal balance of the note
may not be repaid in full to the Company.
Purchased Credit Protection with Identical Underlying Reference Obligations. For single name credit default
swaps and non-tranched index and basket credit default swaps, the Company has purchased protection with a
notional amount of approximately $731 billion and $1,116 billion at December 31, 2014 and December 31, 2013,
respectively, compared with a notional amount of approximately $805 billion and $1,252 billion at December 31,
2014 and December 31, 2013, respectively, of credit protection sold with identical underlying reference
obligations. In order to identify purchased protection with the same underlying reference obligations, the notional
amount for individual reference obligations within non-tranched indices and baskets was determined on a pro
rata basis and matched off against single name and non-tranched index and basket credit default swaps where
credit protection was sold with identical underlying reference obligations.
The purchase of credit protection does not represent the sole manner in which the Company risk manages its
exposure to credit derivatives. The Company manages its exposure to these derivative contracts through a variety
of risk mitigation strategies, which include managing the credit and correlation risk across single name, non-
tranched indices and baskets, tranched indices and baskets, and cash positions. Aggregate market risk limits have
been established for credit derivatives, and market risk measures are routinely monitored against these limits.
The Company may also recover amounts on the underlying reference obligation delivered to the Company under
credit default swaps where credit protection was sold.
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