111-080-1

Value at Risk: Morgan Stanley

In 1994 J.P. Morgan decided to provide direct access to its RiskMetrics1 database to all the market
participants, paving way for the enormous promotion of Value at Risk (VaR) which has turned into
an imperative tool to measure risks. Infamous derivatives mismanagement such as Orange County,
Barings, Metallgesellschaft, Procter and Gamble, Kidder Peadoby, etc., have forced managers to use
VaR in their organizations to understand risk better and prevent any loss of shareholders wealth.

MORGAN STANLEY
In 1933, Glass–Steagall Act2 separated the commercial banking from securities underwriting. It
forced firms like J.P. Morgan & Co.3 to split their commercial banking and investment banking
activities. As a result, J.P. Morgan & Co. decided to spin off its investment banking business to a
new firm, Morgan Stanley, formed by its employees Henry Sturgis Morgan4, Harold Stanley5 and
few others who left J.P. Morgan & Co to carry out securities business. Morgan Stanley was
formally started on September 16, 1935 with US$ 19 million bonds offering for consumer power.6
J.P. Morgan & Co. continued with its commercial banking activities.
In the very first year of operation, Morgan Stanley managed or co-managed US$ 1.1 billion, i.e.,
24% of the market share, in Initial Public Offers (IPOs) and private placements.7 In 1941, the
company was restructured as a partnership business. In 1962, it developed the first computer
model for financial analysis. In 1970, the company employed 250 people and by 1986 Morgan

1
RiskMetrics was established by Sir Dennis Weatherstone Chairman of JP Morgan & Co. in 1989. It
helps to understand the market exposure and sensitivities across a broad range of financial instruments
including, commodities, equities, fixed income securities, forex exchange, mortgages and structured
credit, using multiple Value at Risk (VaR) methodologies and flexible stress-testing.
2
The Banking Act of 1933 was commonly known as Glass–Steagall Act of 1933. It came into existence
after the collapse of American banking system in early 1933.
3
J.P. Morgan & Co. was New York, US based commercial and investment banking firm.
4
Henry Sturgis Morgan, son of John Pierpont "Jack" Morgan, Jr. (J P Morgan Jr.) and grandson of John
Pierpont Morgan (J P Morgan) was one of the founders of Morgan Stanley in 1935.
5
Harold Stanley had joined J. P. Morgan & Co in 1927 as a partner. Later, he became one of the founders
of Morgan Stanley in 1935.
6
“Company History,” www.morganstanley.com/about/company/timeline/index.html#/year/1930.
7
“Company History,” www.morganstanley.com/about/company/timeline/index.html#/year/1930.

This case study was written by Manish Agarwal, IBSCDC, under the direction of D Satish, IBS Hyderabad. It is intended to be used as the basis for
class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was compiled from published
sources.
© 2011, IBSCDC.
No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of
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 111-080-1
Value at Risk: Morgan Stanley

Stanley became a public company by listing on the NYSE8. In 1997, Morgan Stanley, by then, one
of the leading investment banks, merged with Dean Witter, Discover & Company, a brokerage,
mutual fund and credit card Company based in Chicago.9 The merged entity came to be known as
Morgan Stanley Dean Witter. Between fiscal 1997 and 1999, assets under the management of
Morgan Stanley Dean Witter increased from US$ 338 billion to US$ 462 billion. The return on
equity grew by 33% and the share price by 85% in 1999. By 2000, the share price of Morgan
Stanley Dean Witter grew five times due to the boom in stock markets and flourishing investment
banking. In early 2001, Morgan Stanley Dean Witter was renamed Morgan Stanley 10. In February
2001, the company launched the first indices to combine global high yield and emerging market
debts. In March 2003, a consortium led by Morgan Stanley completed China’s largest Non
Performing Loan (NPL) portfolio sales of Renminbi11 (RMB or CNY) 10.8 billion (US$ 1.3 billion). In
August, 2004, the company co-managed US$ 1.9 billion auction IPO for Google, the search engine
leader. In October, 2005, the company advised China Construction Bank on its US$ 9.2 billion IPO, the
largest ever Chinese IPO till date. In August, 2007, the company announced the creation of Morgan
Stanley Carbon Bank12. In April 2008, the company’s private equity arm Morgan Stanley Private
Equity entered into the Indian market. In September 2008, the company advised the US Treasury on
troubled Government sponsored enterprises – Freddie Mac and Fannie Mae. In November 2009, the
company co-managed the US$ 2.6 billion IPO for China Longyuan Electric Power Group Corporation
Limited13. On September 16, 2010, the company celebrated its 75th anniversary.

MARKET RISK At MORGAN STANLEY

Market risk arises due to changes in interest rate, indices, foreign exchange rate, market liquidity, and
price fluctuation. At Morgan Stanley, a major part of the risk arises as a result of trading and
customer facilitation activities, mainly from the Institutional Securities business. In addition to this,
the company faces trading-related market risk within the Global Wealth Management Group.14
Assets Management business of Morgan Stanley faces risks primarily due to capital investment in
real estate funds and investments in private equity vehicles.15 Also, the company is exposed to
interest rate and credit spread risk due to its market-making activities and proprietary trading in
interest rate sensitive financial instruments, for example, risk arising from changes in the level or
implied volatility of interest rates, the timing of mortgage prepayments, the shape of the yield
curve and credit spreads.16
Morgan Stanley is vulnerable to equity price and implied volatility risk due to mark-to-market
in equity securities and derivatives and maintaining proprietary positions (including position
in nonpublic entities). Positions in nonpublic entities may include, but are not limited to,
exposures to private equity, venture capital, private partnerships, real estate funds and other
funds.17 These positions are less liquid, have longer investment horizons and hard to hedge
than listed equities.

8
New York Stock Exchange was US based world largest stock exchange in term of market capitalization.
9
Vivek Gupta and Indu Perepu, Case Study - "Governance Problems at Morgan Stanley", (IBS Center for
Management Research, 2006).
10
Margaret Popper, "The Management Turmoil Muddying Morgan Stanley's Waters,"
www.businessweek.com/bwdaily/dnflash/jan2001/nf20010131_665.htm, January 31, 2001.
11
Renminbi11 (RMB or CNY) is the official currency of China. As of December 2008, US$1 was
approximately equal to RMB 6.82.
12
Morgan Stanley Carbon Bank assisted clients seeking to be carbon neutral. Morgan Stanley Carbon Bank
was the first in offering services like certifying emissions to buying and cancelling carbon credits.
13
China Longyuan Electric Power Group Corporation Ltd. was China’s biggest wind power producer.
14
“Market Risk for Morgan Stanley,” www.wikinvest.com/stock/Morgan_Stanley_(MS)/Market_Risk.
15
“Market Risk for Morgan Stanley,” www.wikinvest.com/stock/Morgan_Stanley_(MS)/Market_Risk.
16
Company’s annual report, 2008.
17
Company’s annual report, 2008.

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Value at Risk: Morgan Stanley

Morgan Stanley is exposed to foreign exchange rate and implied volatility risk due to mark-to-
market in foreign currencies and derivatives, from maintaining foreign exchange positions and
from holding foreign currency denominated financial instruments.18 It is exposed to commodity
prices and implied volatility risk due to mark-to-market activities and maintaining position in
physical commodities such as base metals, crude and refined oil products, natural gas, etc., and
related derivatives. Commodity risks arise due to price fluctuations, which are affected by changes
in demand and supply.

MANAGEMENT OF MARKET RISK

The company has a well-established system to manage market risk. The different business units
and trading desks are responsible to control and manage market risk exposure. The control group
helps in proper measurement and monitoring of these risks.
In addition to this, company has a separate Market Risk Department (MRD). According to the
company’s annual report, the MRD is responsible to ensure transparency of material market risks,
monitoring compliance with established limit and escalating risk concentration to appropriate
senior management.19 To fulfill these responsibilities, the department monitors the risks against the
limits on aggregate risk exposures, performs a verity of risk analysis, regularly reports risk
summaries, and maintains VaR system of the company.
The MRD has designed a number of limits to check price and market liquidity risk. The
department in collaboration with different business units monitors the market risk with the help of
the following measures:
Statistical measures (Use of VaR and other related analytical measures)
Measures of position sensitivity (sensitivity to changes in interest rates, prices implied
volatilities. etc.)
Regular stress testing (this test measures the impact on the value of existing portfolio due to
specific changes in market factors for certain products. This test is performed periodically and
reviewed by trading division risk manger, desk risk manager and MRD)
Regular scenario analyses (this analysis estimates the company’s revenue sensitivity to a set of
specific, predefined market and geopolitical events.)
Material risks identified by the above measures are summarized in reports and circulated for
discussion to senior management.

VALUE at RISK (VaR)

Morgan Stanley uses statistical measure – VaR to measure, monitor and review the market risk of
its trading portfolios. The market risk management department calculates and distributes the VaR-
based risk measures on a daily basis to different levels of management.

VaR METHODOLOGY AND ASSUMPTIONS @ MORGAN STANLEY

The company uses historical simulation and Monte Carlo simulation20 to estimate the VaR (Refer
to Exhibit I for various approach to VaR). The company uses historical simulation for major
market risk factors and Monte Carlo simulation for name-specific risks in equities and fixed (such
as corporate bonds, loans and credit derivatives) income exposures.21

18
“Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations,”
http://seekingalpha.com/news-article/675870-item-7-management-s-discussion-and-analysis-of-financial-
condition-and-results-of-operations, February 28, 2011.
19
Company’s annual report, 2008.
20
Monte Carlo simulation is the computer-based mathematic technique. It allows people to account for risk
in quantitative analysis and decision making.
21
Company’s annual report, 2008.

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Value at Risk: Morgan Stanley

Historical simulation involves constructing a distribution of hypothetical daily changes in the value
of trading portfolios based on two sets of inputs: historical observation of daily changes in key
market indices or other market factors (“market risk factors”); and, information on the sensitivity
of the portfolio values to these market risk factor changes. 22 The company uses around four years
of historical data to estimate the possible changes in market risk factors.
Morgan Stanley’s VaR model takes care of linear as well as nonlinear exposures to price risk,
interest rate risk and credit spread risk, and linear exposures to implied volatility risks. Market
risks captured in the VaR model include equity and commodity prices, interest rates, credit
spreads, foreign exchange rates and associated implied volatilities. The VaR model also covers
correlation risks related to portfolio credit derivatives and some basis risk between corporate debt
and related credit derivatives.
The company’s VaR models have been evolved over time in response to changes in the
composition of trading portfolios and to improvements in modeling techniques and system
capabilities.23 The company regularly enhances the VaR methodologies and assumptions to
capture risks arising due to changes in market structure. The company adds additional systematic
and name-specific risk factors to the VaR model on a regular basis to improve the ability of the
model to estimate accurate risks related to specific asset classes or industry sectors. After high
levels of market volatility during 2008, the company reviewed its VaR model and made some
changes to capture risks generated by certain credit products more accurately.

VaR FOR YEAR 2008

As of November 30, 2008, the aggregate VaR stood at US$ 135 million, almost 63% higher than
the aggregate VaR of 2007. The main reasons were significant increase in interest rate and credit
spread VaR, which was partially offset by reduction in equity prices, foreign exchange rate and
commodity price VaR.
The trading VaR of Morgan had increased by 33% in 2008 from US$ 78 million in 2007 to US$
104 million (Refer Table I for 95% Total VaR) in 2008. This increase was mainly contributed by
increase in interest rate and credit spread VaR, which was partially offset by reduction in equity
prices, foreign exchange rate and commodity price VaR. The Non-trading VaR for the same period
increased by 103% from US$ 33 million in 2007 to US$ 67 million in 2008 mainly due to increase
in interest rate and credit spread VaR.
These VaR numbers (aggregate VaR, Trading VaR and Non-trading VaR) cover almost all
financial instruments generated market risks and managed by the company’s trading businesses.
However, a small percentage of market risk is not covered in VaR such as, risk related to
residential mortgage-backed securities etc. The estimation of these kinds of risks is based upon
approximation.
The aggregate VaR also covers different types of non-trading risks such as –
the interest rate risk generated by funding liabilities related to institutional trading positions,
public company equity positions recorded as investments by the company and
corporate loan exposures that are awaiting distribution to the market24.

22
Company’s annual report, 2008.
23
Company’s annual report, 2008.
24
"Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations,"
http://seekingalpha.com/news-article/675870-item-7-management-s-discussion-and-analysis-of-financial-
condition-and-results-of-operations, February 28, 2011.

4
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Value at Risk: Morgan Stanley

However, aggregate VaR does not include –

certain funding liabilities primarily related to fixed and other non-trading assets and
Credit spread risk generated by the company’s funding liabilities.
As of November 30, 2008, the notional amount of funding liabilities related to non-trading assets25
was around US$ 8.7 billion with the duration of approximately 11 years.
Table I
95% Total VaR
(dollars in millions)
Aggregate
(Trading and Non- Trading Non-trading
trading)
95%/One-Day 95%/One-Day
Primary Market Risk 95%/One-Day VaR
VaR VaR
Category at November 30,
at November 30, at November 30,
2008 2007 2008 2007 2008 2007
Interest rate and credit
127 52 98 45 67 33
spread
Equity price 23 40 23 39 4 4
Foreign exchange rate 14 24 14 25 2 1
Commodity price 23 34 23 34 0 0
Subtotal 187 150 158 143 73 38
Less diversification benefit 52 67 54 65 6 5
Total VaR 135 83 104 78 67 33
Note: Investments made by the Company that are not publicly traded are not reflected in the VaR results
presented
Source: Company’s Annual Report, 2008, pg 93.
Morgan Stanley views average Trading VaR over a period of time as more representative of trends
in the business than VaR at any single point of time.26 The average Trading VaR had increased by
almost 13% from US$ 87 million in 2007 to US$ 98 million in 2008 (Refer Table II for 95%
High/Low/Average Trading and Non-Trading VaR), mainly due to interest rate and credit spread
VaR and foreign exchange rate VaR. The average Total VaR increased from US$ 92 million in
2007 to US$ 115 million in 2008. The reasons were increases in interest rate and credit spread
VaR and foreign exchange rate VaR. The average Non-trading VaR increased by 141% during the
same period from US$ 22 million in 2007 to US$ 53 million in 2008 due to increased risks
associated with certain Non-trading lending positions. At 95% confidence level most of the
frequencies of one day trading VaR were occurring between US$ 97 million and US$ 103 million
(Refer Exhibit II for distribution of the 95% one-day Trading VaR).

25
At Morgan Stanley non-trading assets include – premises, equipment and software, goodwill, deferred tax
assets and intangible assets.
26
Company’s annual report, 2008.

5
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Value at Risk: Morgan Stanley

Table II
95% High/Low/Average Trading and Non-Trading VaR
(dollars in millions)
Primary Market Risk Daily 95%/One-Day VaR Daily 95%/One-Day VaR
Category for Fiscal 2008 for Fiscal 2007
High Low Average High Low Average
Interest rate and credit spread 101 42 69 88 34 46
Equity price 53 17 35 61 29 43
Foreign exchange rate 40 12 25 33 10 18
Commodity price 44 22 35 48 28 37
Trading VaR 114 78 98 108 69 87
Non-trading VaR 96 29 53 61 11 22
Total VaR 143 82 115 123 70 92
Source: Company’s Annual Report, 2008, pg 94.

THE LIMITING FACTOR

Risk analysts state, VaR model helps in the estimation of total market risk exposure of the
portfolio. However, it is based on past data, which may not always properly predict future risks. It
may provide only limited insight into losses. They further said that changes in market value of
portfolio, due to market movement, may differ from the changes estimated by the VaR model.
Morgan Stanley uses VaR as a part of its risk management oversight process. The company also
uses stress testing and scenario analyses. In addition to this, the company has an extensive risk
monitoring, analysis and control system at the trading desk level, division level and company
level.

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Value at Risk: Morgan Stanley

Exhibit I

VaR Methods

Source: Philippe Jorion, Financial Risk Manager Handbook, (John Wiley and Sons, Inc., 2007

Exhibit II
(US$ in millions)

Daily 95%/One-Day Trading VaR for Year Ended on December 31, 2008

Source: Company’s Annual Report, 2008, pg 95.

7
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Value at Risk: Morgan Stanley

References and Suggested Readings:

1. “Item 7. Management's Discussion and Analysis of Financial Condition and Results of

Operations,” http://seekingalpha.com/news-article/675870-item-7-management-s-
discussion-and-analysis-of-financial-condition-and-results-of-operations, February 28,
2011.
2. “Financial and Derivative Instruments,”
www.chevron.com/annualreport/2007/financials/managementsdiscussionandanalysis/financ
ialderivativeinstruments.aspx.
3. Vivek Gupta and Indu Perepu, Case Study – “Governance Problems at Morgan Stanley,”
(IBS Center for Management Research, 2006).
4. “SEC Info - Witter Dean Cornerstone Fund II - 10-K,”
www.secinfo.com/dmfn8.3c.htm, December 31, 2001.
5. “Company History,”
www.morganstanley.com/about/company/timeline/index.html#/year/1930.
6. “Market Risk for Morgan Stanley,”
http://www.wikinvest.com/stock/Morgan_Stanley_(MS)/Market_Risk.
7. Company’s annual report, 2008.