Goldman Sachs 2002 Annual Report Download - page 53

As part of our overall risk control process, daily trading
net revenues are compared with VaR calculated as of the
end of the prior business day. Trading losses incurred on
a single day exceeded our 95% one-day VaR on one
occasion during 2002.
Nontrading Risk
The market risk for financial instruments in our nontrad-
ing portfolio, including our merchant banking invest-
ments, is measured using a sensitivity analysis that
estimates the potential reduction in our net revenues
associated with a 10% decline in equity markets. This
sensitivity analysis is based on certain assumptions
regarding the relationship between changes in the stock
price indices and changes in the fair value of the individ-
ual financial instruments in our nontrading portfolio.
Different assumptions could produce materially different
risk estimates. The sensitivity of our nontrading portfolio
to a 10% equity market decline was $80 million as of
November 2002 compared with $155 million as of
November 2001, reflecting asset dispositions and market
depreciation in the portfolio.
Credit Risk
Credit risk represents the loss that we would incur if a
counterparty, or an issuer of securities or other instru-
ments we hold, fails to perform under its contractual
obligations to us. To reduce our credit exposures, we
seek to enter into netting agreements with counterparties
that permit us to offset receivables and payables with
such counterparties. In addition, we attempt to further
reduce credit risk with certain counterparties by entering
into agreements that enable us to obtain collateral from
a counterparty or to terminate or reset the terms of
transactions after specified time periods or upon the
occurrence of credit-related events, by seeking third-
party guarantees of the counterparty’s obligations, and
through the use of credit derivatives and other structures
and techniques.
For most businesses, counterparty credit limits are estab-
lished by the Credit Department, which is independent of
the revenue-producing departments, based on guidelines
set by the Firmwide Risk Committee and the Credit
Policy Committee. For most products, we measure and
limit credit exposures by reference to both current and
potential exposure. We typically measure potential expo-
sure based on projected worst-case market movements
over the life of a transaction within a 95% confidence
interval. For collateralized transactions we also evaluate
potential exposure over a shorter collection period, and
give effect to the value of received collateral. We further
seek to measure credit exposure through the use of sce-
nario analyses, stress tests and other quantitative tools.
Our global credit management systems monitor current
and potential credit exposure to individual counterparties
and on an aggregate basis to counterparties and their
affiliates. The systems also provide management, includ-
ing the Firmwide Risk and Credit Policy Committees,
with information regarding overall credit risk by product,
industry sector, country and region.
Derivatives
Derivative contracts are financial instruments, such as
futures, forwards, swaps or option contracts, that derive
their value from underlying assets, indices, reference rates
or a combination of these factors. Derivative instruments
may be privately negotiated contracts, which are often
referred to as OTC derivatives, or they may be listed and
traded on an exchange.
Most of our derivative transactions are entered into for
trading purposes. We use derivatives in our trading activ-
ities to facilitate customer transactions, to take propri-
etary positions and as a means of risk management. We
also enter into derivative contracts to manage the interest
rate and currency exposure on our long-term borrowings.
Derivatives are used in many of our businesses, and we
believe that the associated market risk can only be under-
stood relative to the underlying assets or risks being
hedged, or as part of a broader trading strategy.
Accordingly, the market risk of derivative positions is
managed with all of our other nonderivative risk.
Derivative contracts are reported on a net-by-counter-
party basis in our consolidated statements of financial
condition where management believes a legal right of
setoff exists under an enforceable netting agreement. For
an OTC derivative, our credit exposure is directly with
our counterparty and continues until the maturity or ter-
mination of such contract.
Managem ent’s D iscussion and A nalysis
GO L D M A N SA CH S 2002 A N N UAL R EPO RT 51