Goldman Sachs 2004 Annual Report Download - page 59

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GOLDMAN฀SAC H S ฀ 2004฀ A N N U A L ฀ R E P ORT ฀ ฀ ฀ 5 7
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 ฀ ฀ ฀ 5 7
We seek to manage these risks through diversifying exposures,
controlling position sizes and establishing hedges in related securi-
ties or derivatives. For example, we may hedge a portfolio of
common stocks 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 secu-
rity 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 management
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;
• scenario analyses, stress tests and other analytical tools that
measure the potential effects on our trading net revenues of
various market events, including, but not limited to, a large
widening of credit spreads, a substantial decline in equity mar-
kets and significant moves in selected emerging markets; and
• inventory position limits for selected business units.
VaR
VaR is the potential loss in value of Goldman Sachs’ trading
positions due to adverse market movements over a defined time
horizon with a specified confidence 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
1 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 accumulate over a longer time
horizon such as a number of consecutive trading days.
The VaR numbers below are shown separately for interest rate,
equity, currency and commodity products, as well as for our
overall trading positions. The VaR numbers in each risk cate-
gory 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 approximations. While
management believes that these assumptions and approxima-
tions are reasonable, there is no uniform industry methodology
for estimating VaR, and different assumptions and/or approxi-
mations could produce materially different VaR estimates.
We use historical data to estimate our VaR and, to better reflect
current asset volatilities, we generally weight historical 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 calcu-
lated 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. Changes in VaR between reporting peri-
ods are generally due to changes in levels of exposure, volatilities
and/or correlations among asset classes.
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