Goldman Sachs 2004 Annual Report Download - page 41

GOLDMAN฀SAC H S ฀ 2004฀ A N N U A L ฀ R E P ORT ฀ ฀ ฀ 3 9
management’s฀discussion฀and฀analysis
management’s฀discussion฀and฀analysis
GOLDMAN฀SAC H S ฀ 2004฀ A N N U A L ฀ R E P ORT ฀ ฀ ฀ 3 9
We enter into certain OTC option transactions that provide us
or our counterparties with the right to extend the maturity of
the underlying contract. The fair value of these option contracts
is not material to the aggregate fair value of our OTC derivative
portfolio. In the tables above, for option contracts that require
settlement by delivery of an underlying derivative instrument,
the classification of the remaining contractual maturity is gener-
ally based upon the maturity date of the underlying derivative
instrument. In those instances when the underlying instrument
does not have a maturity date or either counterparty has the
right to settle in cash, the remaining contractual maturity date
is generally based upon the option expiration date.
Price transparency for OTC derivative model inputs varies
depending on, among other factors, product type, maturity and
the complexity of the contract. Price transparency for interest
rate and currency contracts varies by the underlying currencies,
with the currencies of the leading industrialized nations having
the most price transparency. Price transparency for commodity
contracts varies by type of underlying commodity. Price trans-
parency for equity contracts varies by market, with the equity
markets of the leading industrialized nations having the most
price transparency. Price transparency is inherently more limited
for more complex structures because they often combine one or
more product types, requiring additional inputs such as correla-
tions and volatilities.
principal฀ i n v estments ฀–฀In valuing our corporate and real
estate principal investments, we separate our portfolio into
investments in private companies, investments in public compa-
nies (excluding our investment in the convertible preferred stock
of SMFG) and our investment in SMFG.
Our private principal investments, by their nature, have little or
no price transparency. Such investments are initially carried at
cost as an approximation of fair value. Adjustments to carrying
value are made if there are third-party transactions evidencing a
change in value. Downward adjustments are also made, in the
absence of third-party transactions, if we determine that the
expected realizable value of the investment is less than the car-
rying value. In reaching that determination, we consider many
factors including, but not limited to, the operating cash flows
and financial performance of the companies or properties relative
to budgets or projections, trends within sectors and/or regions,
underlying business models, expected exit timing and strategy,
and any specific rights or terms associated with the investment,
such as conversion features and liquidation preferences.
Our public principal investments, which tend to be large,
concentrated holdings that result from initial public offerings or
other corporate transactions, are valued using quoted market
The following table sets forth the carrying value of our principal investments portfolio:
principal฀investments
฀ ฀ AS฀OF฀NOVEMBER
฀ ฀ 2004฀2003
(IN฀MILLIONS)฀ CORPORATE฀ REAL฀ESTATE฀ TOTAL฀ CORPORATE฀ REAL฀ESTATE฀ TOTAL
Private $฀ ฀935฀ $769฀ $1,704฀ $1,054฀ $757฀ $1,811
Public 343฀ 51฀ 394฀ 219฀ 42฀ 261
Subtotal 1,278฀ 820฀ 2,098฀ 1,273฀ 799฀ 2,072
SMFG convertible preferred stock(1) 2,556฀ —฀ 2,556฀ 1,683฀ —฀฀ 1,683
Total(2)฀ $3,834฀ $820฀ $4,654฀ $2,956฀ $799฀ $3,755
฀
(1)฀฀The฀fair฀value฀of฀our฀Japanese฀yen-denominated฀investment฀in฀SMFG฀convertible฀preferred฀stock฀includes฀the฀effect฀of฀foreign฀exchange฀revaluation.฀We฀hedge฀
our฀economic฀exposure฀to฀exchange฀rate฀movements฀on฀our฀investment฀in฀SMFG฀by฀borrowing฀Japanese฀yen.฀Foreign฀exchange฀revaluation฀on฀the฀investment฀and฀
the฀related฀borrowing฀are฀generally฀equal฀and฀offsetting.฀For฀example,฀if฀the฀Japanese฀yen฀appreciates฀against฀the฀U.S.฀dollar,฀the฀U.S.฀dollar฀carrying฀value฀of฀our฀
SMFG฀investment฀will฀increase฀and฀the฀U.S.฀dollar฀carrying฀value฀of฀the฀related฀borrowing฀will฀also฀increase฀by฀an฀amount฀that฀is฀generally฀equal฀and฀offsetting.
(2)฀฀Excludes฀assets฀of฀$1.28฀billion฀and฀$1.07฀billion฀in฀consolidated฀employee-owned฀merchant฀banking฀funds฀as฀of฀November฀2004฀and฀November฀2003,฀respectively.
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prices discounted for restrictions on sale. If liquidating a position
is reasonably expected to affect market prices, valuations are
adjusted accordingly based on predetermined written policies.
Our investment in the convertible preferred stock of SMFG is
carried at fair value, which is derived from a model that incor-
porates SMFG’s common stock price and credit spreads, the
impact of nontransferability and illiquidity and the downside
protection on the conversion strike price. The fair value of our
investment is particularly sensitive to movements in the SMFG
common stock price. As a result of transfer restrictions and the
downside protection on the conversion strike price, the relation-
ship between changes in the fair value of our investment and
changes in SMFG’s common stock price is nonlinear. During the
fiscal year, the fair value of our investment increased 42%
(expressed in Japanese yen), primarily due to an increase in the
SMFG common stock price and the passage of time in respect
of the transfer restrictions on the underlying common stock.