Morgan Stanley 2015 Annual Report Download - page 120

Credit Exposure—Derivatives.
The Company incurs credit risk as a dealer in over-the-counter (“OTC”) derivatives. Credit risk with respect to derivative
instruments arises from the failure of a counterparty to perform according to the terms of the contract. In connection with its
OTC derivative activities, the Company generally enters into master netting agreements and collateral arrangements with
counterparties. These agreements provide the Company with the ability to demand collateral, as well as to liquidate collateral
and offset receivables and payables covered under the same master netting agreement in the event of counterparty default.
The Company manages its trading positions by employing a variety of risk mitigation strategies. These strategies include
diversification of risk exposures and hedging. Hedging activities consist of the purchase or sale of positions in related
securities and financial instruments, including a variety of derivative products (e.g., futures, forwards, swaps and options).
For credit exposure information on the Company’s OTC derivative products, see Note 4 to the consolidated financial
statements in Item 8.
Credit Derivatives. A credit derivative is a contract between a seller and buyer of protection against the risk of a credit
event occurring on one or more debt obligations issued by a specified reference entity. The buyer typically pays a periodic
premium over the life of the contract and is protected for the period. If a credit event occurs, the seller is required to make
payment to the beneficiary based on the terms of the credit derivative contract. Credit events, as defined in the contract, may
be one or more of the following defined events: bankruptcy, dissolution or insolvency of the referenced entity, failure to pay,
obligation acceleration, repudiation, payment moratorium and restructurings.
The Company trades in a variety of credit derivatives and may either purchase or write protection on a single name or
portfolio of referenced entities. In transactions referencing a portfolio of entities or securities, protection may be limited to a
tranche of exposure or a single name within the portfolio. The Company is an active market maker in the credit derivatives
markets. As a market maker, the Company works to earn a bid-offer spread on client flow business and manages any residual
credit or correlation risk on a portfolio basis. Further, the Company uses credit derivatives to manage its exposure to
residential and commercial mortgage loans and corporate lending exposures during the periods presented. The effectiveness
of the Company’s credit default swap (“CDS”) protection as a hedge of its exposures may vary depending upon a number of
factors, including the contractual terms of the CDS.
The Company actively monitors its counterparty credit risk related to credit derivatives. A majority of the Company’s
counterparties are composed of banks, broker-dealers, insurance and other financial institutions. Contracts with these
counterparties may include provisions related to counterparty rating downgrades, which may result in the counterparty
posting additional collateral to the Company. As with all derivative contracts, the Company considers counterparty credit risk
in the valuation of its positions and recognizes credit valuation adjustments as appropriate within Trading revenues in the
consolidated statements of income.
Credit Derivative Portfolio by Counterparty.
At December 31, 2015
Fair Values(1) Notionals
Receivable Payable Net
Protection
Purchased Protection Sold
(dollars in millions)
Banks and securities firms ...................... $ 16,962 $ 17,295 $ (333) $ 533,557 $ 491,267
Insurance and other financial institutions ........... 5,842 6,247 (405) 189,439 194,723
Non-financial entities .......................... 115 123 (8) 5,932 3,529
Total ................................... $ 22,919 $ 23,665 $ (746) $ 728,928 $ 689,519
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