Goldman Sachs 2002 Annual Report Download - page 50

We seek to manage these risk exposures through diversi-
fying exposures, controlling position sizes and establish-
ing hedges in related securities or derivatives. For
example, we may hedge a portfolio of common stock by
taking an offsetting position in a related equity-index
futures contract. The ability to manage an exposure may,
however, be limited by adverse changes in the liquidity of
the security or the related hedge instrument and in the
correlation of price movements between the security and
related hedge instrument.
In addition to applying business judgment, senior man-
agement uses a number of quantitative tools to manage
our exposure to market risk. These tools include:
•risk limits based on a summary measure of market
risk exposure referred to as VaR;
•risk limits based on scenario analyses that measure
the potential effects on our trading net revenues of
various market events, including a large widening
of credit spreads, a substantial decline in equities
markets and significant moves in emerging mar-
kets; and
•inventory position limits for selected business units
and country exposures.
var —VaR is the potential loss in value of Goldman
Sachs’ trading positions due to adverse market move-
ments over a defined time horizon with a specified confi-
dence level.
For the VaR numbers reported below, a one-day time
horizon and a 95% confidence level were used. This
means that there is a one in 20 chance that daily trading
net revenues will fall below the expected daily trading net
revenues by an amount at least as large as the reported
VaR. Thus, shortfalls from expected trading net revenues
on a single trading day greater than the reported VaR
would be anticipated to occur, on average, about once a
month. Shortfalls on a single day can exceed reported
VaR by significant amounts. Shortfalls can also accumu-
late over a longer time horizon such as a number of con-
secutive trading days.
The VaR numbers below are shown separately for inter-
est rate, equity, currency and commodity products, as
well as for our overall trading positions. These VaR num-
bers include the underlying product positions and related
hedges that may include positions in other product areas.
For example, the hedge of a foreign exchange forward
may include an interest rate futures position, and the
hedge of a long corporate bond position may include a
short position in the related equity.
The modeling of the risk characteristics of our trading
positions involves a number of assumptions and approx-
imations. While management believes that these assump-
tions and approximations are reasonable, there is no
uniform industry methodology for estimating VaR, and
different assumptions and/or approximations could pro-
duce materially different VaR estimates.
We use historical data to estimate our VaR and, to better
reflect current asset volatilities, we generally weight his-
torical data to give greater importance to more recent
observations. Given its reliance on historical data, VaR is
most effective in estimating risk exposures in markets in
which there are no sudden fundamental changes or shifts
in market conditions. An inherent limitation of VaR is
that the distribution of past changes in market risk factors
may not produce accurate predictions of future market
risk. Different VaR methodologies and distributional
assumptions could produce a materially different VaR.
Moreover, VaR calculated for a one-day time horizon does
not fully capture the market risk of positions that cannot
be liquidated or offset with hedges within one day.
Managem ent’s D iscussion and A nalysis
48 G O L D M A N SA CH S 2002 AN N UA L R EPO RT