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Case 4. Morgan Stanley and The Market Risk
Case 4. Morgan Stanley and The Market Risk
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
the copyright owner.
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.
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.
2
111-080-1
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.
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.
3
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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.
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
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.
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.
6
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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
7
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Value at Risk: Morgan Stanley