P1.T1. Foundations of Risk

Bionic Turtle FRM Practice Questions

Allen, Chapter 4: Financial Disasters

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ALLEN, CHAPTER 4: FINANCIAL DISASTERS ................................................................................ 1 KEY IDEAS ............................................................................................................................................ 3 P1.T1.50. CHASE MANHATTAN BANK/DRYSDALE SECURITIES .................................................................... 4 P1.T1.51. KIDDER PEABODY................................................................................................................... 6 P1.T1.52. BARINGS ............................................................................................................................... 8 P1.T1.53. ALLIED IRISH BANK .............................................................................................................. 10 P1.T1.54. LONG TERM CAPITAL MANAGEMENT....................................................................................... 13 P1.T1.55. METALLGESELLSHAFT ........................................................................................................... 17 P1.T1.56. BANKER’S TRUST ................................................................................................................. 20

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Key Ideas Allen establishes three categories of financial disasters:

Due to misleading reporting (incorrect market information): cases where the “striking feature” is that a firm, or its investors and lenders, have been misled with deliberate intent about the size and nature of its position(s)

Due to large market moves: positions were known, but market moves were not anticipated

Due to conduct of customer business: did not involve any direct financial loss to the firm, but were completely a matter of reputational risk due to the conduct of customer business.

A few tips:

In terms of specific case study facts, the exam may be more likely to query LTCM or Metallgesellschaft (and secondarily, Barings and Banker’s Trust ) than the others. We would recommend starting with these two (four).

Please note the prevalence of operational risk, including its various sub-classes of risk. Operational risk is highly testable w.r.t. these cases (after OpRisk, Market Risk)

Please be mindful of the difference between outright fraud (e.g., Leeson at Barings) and non-fraud: neither LTCM nor Metallgesellschaft involved deception

• Chase/Drysdale

• Kidder Peabody

• Barings

• Allied Irish Bank

• Union bank of Switzerland (UBS)

Misleading Reporting

• LTCM

• Metallgesellschaft

Unexpected market moves

• Banker’s Trust

Conduct of Customer Business

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Allen, Chapter 4: Financial Disasters

P1.T1.50. Chase Manhattan Bank/Drysdale Securities

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Chase Manhattan and their involvement with Drysdale Securities 50.1 Steven Allen classifies the Drysdale bankruptcy as which type of financial disaster?

a) Case in which firm/investors were misled (misleading reporting) b) Losses from unexpectedly large market moves (disasters due to large market moves) c) Fiduciary or reputational exposure to customer positions (due to conduct of

customer business) d) None of the above

50.2 The key lesson learned from the Drysdale bankruptcy concerned what practice?

a) Need to investigate stream of large profits b) Need to separate front and back offices c) Correlations spike to almost one in a crisis d) Collateral value determination

50.3 Of which bond feature did Drysdale take systematic advantage?

a) Embedded call option b) Short-term yield volatility c) Accrued coupon interest d) Long-maturity bond duration

P1.T1.50. CHASE MANHATTAN BANK/DRYSDALE SECURITIES P1.T1.51. KIDDER PEABODY P1.T1.52. BARINGS P1.T1.53. ALLIED IRISH BANK P1.T1.54. LONG TERM CAPITAL MANAGEMENT P1.T1.55. METALLGESELLSHAFT P1.T1.56. BANKER’S TRUST

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Answers: 50.1 A. (Misleading reporting) “There is not much question as to how Drysdale managed to obtain the unsecured funds. They took systematic advantage of a computational shortcut in determining the value of borrowed securities.” 50.2. D. (collateral value determination) “The securities industry as a whole learned that it needed to make its methods for computing collateral value on bond borrowings more precise. Chase, and other firms who may have had similar control deficiencies, learned the need for a process that forced areas contemplating new product offerings to receive prior approval from representatives of the principal risk control functions within the firm. 50.3 C. (Accrued coupon interest) “To save time and effort, borrowed securities were routinely valued as collateral without accounting for accrued coupon interest. By seeking to borrow large amounts of securities with high coupons and a short time left until the next coupon date, Drysdale could take advantage of the difference in the amount of cash the borrowed security could be sold for (which INCLUDED accrued interest) and the amount of cash collateral that need to be posted against the borrowed security (which did NOT include accrued interest). Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-50-chase-manhattan-bank-drysdale-securities.3574/

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P1.T1.51. Kidder Peabody

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Kidder Peabody 51.1. What happened at Kidder Peabody?

a) Kidder Peabody lost ~$350 million in cash due to market risk b) Kidder Peabody lost ~$350 million in cash due to operational risk c) Previously reported booked gains of ~$350 were found to be artificial d) Collateral calls of about $350 million triggered a bankruptcy

51.2 Which enabled the failure at Kidder Peabody?

a) Jett exceeded position limits in regard Treasury STRIPS b) Jett took positions in forward recons, which were prohibited instruments c) Accounting loophole in regard to collateral valuation d) Accounting loophole in regard to forward contracts

51.3 Which is the lesson(s) learned from the failure at Kidder Peabody?

a) Make sure you understand the source of a large, unexpected profits b) Periodically review models and systems c) Both (A) and (B) d) Neither (A) nor (B)

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Answers: 51.1 C. (artificial gains) “Joseph Jett entered into a series of trades that were incorrectly reported in the firm’s accounting system, artificially inflating reported profits. When this was ultimately corrected in April 1994, $350 million in previously reported gains had to be reversed � Jett’s trades had not resulted in any actual loss of cash for Kidder.” � although it is estimated that he additionally hid about $85 million in actual losses 51.2. D. (Accounting loophole in regard to forward “recon” contracts) In regard to (A) and (B), these are false as “The IS specialists discovered that none of Jett’s trade deals were ever consummated. This meant that while no securities had ever changed hands, the profits associated with these allegedly fictitious trades had been accounted for as income on Kidder’s books.” Rather, Jett exploited the fact that the IS/accounting system allowed him to book the profit on a forward (recon) transaction. 51.3. C. Both (A) and (B) “Two lessons can be drawn from this: Always investigate a stream of large unexpected profits thoroughly and make sure you completely understand the source. Periodically review models and systems to see if changes in the way they are being used require changes in simplifying assumptions.” Reference: Not the assigned chapter, but this brief piece from NYU is a helpful summary: https://www.dropbox.com/s/0rjfdpqbetawpzj/kidder_nyu.pdf Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-51-kidder-peabody.3577/

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P1.T1.52. Barings

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Barings 52.1 Which is true about Nick Leeson’s failed positions?

a) His profits were fictitious but actual losses were less than $10 million b) His actual positions were non-directional arbitrages that failed due to basis risk c) His actual positions were unhedged directional bets that Nikkei would increase (net

long Nikkei) d) His actual positions were unhedged directional bets that Nikkei would decrease (net

short Nikkei) 52.2 Based on the assigned reading, what was arguably the largest single failure by the management of Barings?

a) They did not implement position limits for all possible instruments b) They allowed Leeson to be both chief trader and head of settlements c) Positions should have required daily cash settlement (margin would have exposed

the losses) d) They did not hire a consultant to implement training to build risk awareness and

promote a risk culture 52.3 What was the EVENT RISK that manifested in the Barings case?

a) Kobe earthquake in 1995 b) Asian turmoil of 1997 c) Russian bond defaults in 1998 d) September 11, 2001 terrorist attacks

52.4 According to Allen, each of the following is a lesson to be learned from the Barings case EXCEPT for:

a) Absolute necessity of an independent trading office b) Need to make inquiries into unexpected sources of profit c) Need to inquire into large, unanticipated movements of cash d) Need to attach clawback feature to annual bonus compensation

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Answers: 52.1 C. His actual positions were unhedged directional bets that Nikkei would increase (net long Nikkei) Although Leeson was authorized to conduct arbitrage (exchange switching) and to make unhedged (directional) bets within limits (“Leeson was only allowed to make unhedged trades on up to 200 Nikkei 225 futures, 100 Japanese Government Bonds, and 500 euroyen futures contract.”), he nevertheless entered into, and hid, huge directional bets that would have been profitable generally if the Nikkei would have remained flat or increases. Specifically, he write sizable put options (short options). In regard to (B), Leeson “was supposed to be running a low-risk, limited return arbitrage business for Barings in Singapore” but he disguised his speculative positions. 52.2 B. They allowed Leeson to be both chief trader and head of settlements The most egregious violation was that Leeson was allowed to simultaneously, effectively manage both the front and back offices. Allen: “the most blatant of management failures was an attempt to save money by allowing Leeson to function as head of trading and the back office at an isolated branch.” In other words, he was able to facilitate the fraud because there was no independent back office. 52.3 A. Kobe earthquake in 1995 The Kobe earthquake (http://en.wikipedia.org/wiki/Great_Hanshin_earthquake) had a very negative impact on Leeson’s positions. First, it sent the Nikkei plummeting. Second, it increased market volatility; Leeson had written options so he was short volatility. 52.4 D. Need to attach clawback feature to annual bonus compensation Allen articulates (A), (B) and (C) but not clawbacks. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-52-barings.3579/

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P1.T1.53. Allied Irish Bank

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Allied Irish Bank (IAB) 53.1 John Rusnak’s fraud was similar to Nike Leeson’s in which respect?

a) Ran the back office while conducting trades b) Generated large unexplained profits from relatively small operation c) Used imaginary transactions to conceal real transactions d) Used futures markets with daily settlement rather than OTC forwards

53.2 According to Allen, which was AIB management’s “most egregious” control failure?

a) Failure to employ diversification and hedge techniques b) Failure to use a risk metric such as Value at Risk (VaR) c) Failure to direct trades to the prime brokerage account d) Failure to confirm all trades

53.3 According to Allen, the internal audits failed for EACH of the following reasons EXCEPT for:

a) Small samples b) Confusing daily profit & loss (P&L) with cash flows c) Auditors inexperienced in FX options d) Over-reliance on trust in Rusnak’s character

53.4 According to Allen, lessons learned from AIB include EACH of the following EXCEPT for:

a) Value at Risk (VaR) was an inappropriate measure for these non-linear positions b) Efforts to reduce expenses (increase profits) led to tolerance for weakening controls c) The back office was not allowed to exercise its independence d) Outside control groups did not have access to direct trading information

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Answers: 53.1 C. Used imaginary transactions to conceal real transactions In regard to (A), Leeson effective ran the back office but Rusnak did not. In regard to (B), Rusnak “was extremely modest in the amount of false profit he claimed so he did not set off the warning flags of large unexplained profits from small operations, which Leeson and Jett at Kidder Peabody triggered in their desire to collect large bonuses.” In regard to (D), Rusnak “had the offsetting advantage that he was operating in an over-the-counter market in which there was not a need to put up cash against losses.” 53.2 D. Failure to confirm trades Allen relies on the Ludwig report which, in regard to CONTROL DEFICIENCIES said, “The most critical risk control lapse was in the operation of the back office with respect to confirmation of trades. The ostensible policy at Allfirst treasury was to confirm all trades, as they should be under the basic standard practice in the industry. But Mr. Rusnak was somehow able to bully or to cajole the operations staffer responsible for confirming Mr. Rusnak’ s trades into not confirming all of them. The staffer claims that, due to the absence of any net cash payment and the difficulty in confirming trades in the middle of the night, a decision was made at a meeting in early 2000 attended by other treasury staff senior to him not to confirm offsetting pairs of options trades with Asian counterparties.” In regard to (B), AIB used a VaR but Rusnak manipulated it. 53.3 B. (Allen implicates small spot audits, inexperience in FX option, and over-reliance on Rusnak’s character). Of particular interest is the failure of the auditors to use sufficient samples. From the Ludwig report, “In 1999, internal audit of treasury operations undertook no sample of Mr. Rusnak’ s transactions to see if they had been properly confirmed. In August 2000, a further internal audit of treasury operations sampled 25 transactions to see if they had been properly confirmed. Of those 25, only one was a foreign exchange option (the majority of the transactions sampled were exchange-traded products that had relatively low confirmation risk). The one foreign exchange option sampled turned out to be genuine. Yet roughly 50 percent of the 63 foreign exchange options on the books at that time were bogus. Had the auditors included even just a few additional options in their sample of transactions, the overall probability of detecting a bogus one would have increased dramatically.”

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53.4 A. (B, C, and D are emphasized) In regard to VaR, AIB did utilize VaR, but (i) it was rendered meaningless by Rusnak’s “gross manipulation” and (ii) the Ludwig report does not assert VaR was inappropriate but rather that “In addition to the use of VaR, AIB should use stress testing and scenario analysis to report and control risk. These methods highlight “ long tail” or “ event” risks which, while not probable, can be ruinous.” � this last assertion is quite thematic in the FRM: since VaR does not quantify extreme tail losses, it must be complemented, typically with stress testing and scenario analysis. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-53-allied-irish-bank.3583/

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P1.T1.54. Long Term Capital Management

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Long Term Capital Management (LTCM) Please note: this question is based on the FRM assignment (Steve Allen); he acknowledges some areas of disagreement with other commentators. 54.1 Which best describes the prevailing strategy employed by LTCM in its initial, successful years?

a) Relative value b) Event-driven c) Distressed debt d) Global macro

54.2 Which of the following is true about LTCM?

a) Some LTCM employees were indicted for fraud b) U.S. government (public) funds were used to bailout LTCM c) LTCM employed value at risk (VaR) models d) Regulators and auditors warned about LTCM’s leverage

54.3 What does Allen call the Achilles heel (i.e., key weakness) in LTCM’s strategy?

a) Interest rate exposure b) Liquidity exposure c) Currency exposure d) Counterparty exposure

54.4 Each of the following contributed, directly or indirectly, to LTCM’s problems EXCEPT for:

a) Salomon Brothers liquidation of positions b) LTCM seeking new equity c) Russian debt default d) Narrowing of interest rate spreads

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54.5 How does Allen criticize LTCM’s usage of value at risk (VaR)?

a) For not using VaR b) For not using a longer horizon c) For not using a higher confidence d) For not using a liquidity-adjusted VaR

54.6 The lessons learned from LTMC include EACH of the following EXCEPT for:

a) Better use of stress tests in assessing credit risk b) Need for initial margin if counterparty’s principal business is trading c) Need to train new personnel in compliance, disclosure and capital requirements d) Need to incorporate endogenous and exogenous liquidity risks

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Answers: 54.1 A. (relative value;a.k.a. “convergence trade,” primary of fixed income) Steven Allen (assigned) gives the example of a converge trade on the spread between U.S. interest rate swaps and U.S. government bonds. In regard to (D), this is arguably an acceptable answer in their later years as they “style drifted” into directional exposures. 54.2 C. (LTCM did employ VaR models, but they failed to “supplement VaR with a full set of stress test scenarios”). In regard to (A), (B), and (D): none are true! The Federal Reserve coordinated (coerced?) the consortium of creditors, but no public bailout money was spent; nobody was accused of fraud, no legal accusations were made; and finally, no regulators or auditors made any warnings (although leverage was high at 28:1 but comparable to investment banks at the time) 54.3 B. (liquidity exposure to margin calls) The key to Allen’s interpretation is that LTCM was able to avoid positing INITIAL MARGIN in over-the-counter markets (due to its “track record of excellent returns”) which exacerbated its sensitivity to ongoing margin calls, in the event of spread divergence (rather than the hoped-for convergence): “Because they were seeking opportunities where market pressures were causing deviation from long-run relationships, a strong possibility always existed that the same market pressures would push the deviation even further. LTCM would then immediately need to come up with the cash to fund the change in market valuation.” 54.4 D. Narrowing of interest rate spreads Narrow spreads (convergence) was their strategy; a “flight to quality” caused temporal divergence. In regard to (A), Salomon has similar positions to LTCM, so their selling made the situation worse. In regard to (B), LTCM seeking equity created two problems: 1. rumors drove prices down further, and 2. LTCM was forced to disclose position information. In regard to (C), the Russian debt default was the “event risk” trigger

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54.5. D. For not using a liquidity-adjusted VaR Allen: “Another point on which LTCM’s risk management could be criticized is a failure to account for the illiquidity of its largest positions in its VaR or stress runs.” 54.6 C. Need to train new personnel in compliance, disclosure and capital requirements In regard to (D), Allen writes of the need for “Factoring the potential costs of liquidating positions in an adverse market environment into estimates of the price at which trades can be unwound. These estimates should be based on the size of positions as well as the general liquidity of the market.” Note: size of position refers to endogenous liquidity risk; liquidity of market refers to exogenous risk. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-54-long-term-capital-management-ltcm.3587/

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P1.T1.55. Metallgesellshaft

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Metallgesellschaft 55.1 The Metallgesellschaft case highlights each of the following risks EXCEPT for:

a) Funding liquidity risk b) Basis risk c) Roll (rollover) risk, in contango d) Lack of management supervision (operational risk)

55.2 Allen draws EACH of the following lessons from Metallgesellschaft EXCEPT FOR:

a) It is inappropriate to hedge long-term contracts with short-term hedges b) Short-term hedges against long-term contracts can succeed with proper risk

controls c) Because roll risk is key and uncertain, conservative valuation reserves for roll cost

are necessary d) Liquidity considerations may require a hedge that is appropriate but not the

theoretical minimum variance

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Answers: 55.1 D. Lack of management supervision (operational risk) In regard to (A), (B), and (C), the primary issue highlights all three risks: MG hedged short positions in long-term forward with long positions in short-term futures contracts (stack-and-roll). In the shift to contango, the roll return become negative and the DAILY SETTLEMENT of the futures contracts (unlike the forward contracts) exposed the BASIS RISK of the hedge and, ultimately, the essential FUNDING LIQUIDITY RISK problem. 55.2 A. It is inappropriate to hedge long-term contracts with short-term hedges Allen says “it is often a key component of a market maker’s business strategy to extend available liquidity in a market. This requires the use of shorter-term hedges against longer-term contracts.” In regard to (B), (C), and (D): these reflect Allen’s key lessons. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-55-metallgesellschaft.3592/

Metallgesellshaft (MGRM) summary

MGRM wrote (sold) long-term forward contracts to sell gas/oil MGRM hedged the short long-term forward contracts with long positions in short-

term futures contracts via a stack-and-roll hedge As spot oil prices dropped, oil futures curve shifted to contango

o When oil shifted to contango, their roll yield (roll return) turned negative, just as the roll return has previously been profitable for MGRM under oil backwardation. Again, under contango, the long (short) futures position experiences losses (gains) on the roll return component. Under backwardation, the long (short) futures position experiences gains (losses) on the roll return component.

In 1993, creditors rescued with a $1.9 billion package

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Metallgesellschaft: Key Factors

1. First factor was that the market shifted to contango (i.e., futures price is greater than the spot price) that exploited the basis risk. Stack-and-roll hedge exposes to basis risk Shift to contango created losses on roll return Greatly increased the cost of the stack-and-roll hedge. Led to cash flow (liquidity) problems

2. Second factor was German accounting methods required Metallgesellschaft to show

futures losses (i.e., from hedge) but could not recognize unrealized gains from the forward. Accounting standards required recognition of futures losses but not forward

gains! These reported losses triggered margin calls and a panic, which led to credit

rating downgrades.

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P1.T1.56. Banker’s Trust

AIM: Describe the key factors that led to and the lessons learned from the following risk management case studies: Bankers’ Trust. 56.1 Allen divides financial disasters into three broad categories. Where does he slot Bankers’ Trust?

a) Disaster due to misleading reporting b) Disaster due to large market moves c) Disaster due to conduct of customer business d) All of the above

56.2 Which is true about the issue between Bankers’ Trust and Procter & Gamble (P&G)?

a) P&G was a new client to Banker’s Trust in 1994 b) The transaction at issue was a complex interest-rate derivative c) The intent of P&G was to implement a tailored hedge d) Banker’s Trust asserted its fiduciary role with respect to P&G

56.3 According to Allen, lessons learned from Bankers’ Trust included each of the following EXCEPT for:

a) Complex transaction make comparison shopping difficult and make clients more dependent on advisor

b) Price quotes provided to customers should be made by an independent back office c) People and firms should be cautious about communications (e.g., email) that can

later be made public d) Some transactions are sufficiently complex that their costs outweigh their benefits

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Answers: 56.1 C. Disaster due to conduct of customer business 4.3 Disasters due to the conduct of customer business: “In this section, we focus on disasters that did not involve any direct financial loss to the firm, but were completely a matter of reputational risk due to the conduct of customer business” 56.2 B. The transaction at issue was a complex interest-rate derivative The “sheer complexity” of the transaction was at the heart of the dispute and appears to generally not be in dispute. In regard to (A), P&G “had been entering into such trades for several years prior to 1994 with good results.” In regard to (C), P&G was seeking to REDUCE FUNDING COST (consequently that had directional exposure to a rise in interest rates) and “the derivatives were not tailored to any particular needs of P&G or Gibson” In regard to (D), BT asserted that it was NOT acting in an advisory (fiduciary) role to P&G, since the firm had retained its own outside experts to create interest rate forecasts. Notice how this issue resembles Goldman Sachs’ position with respect to the ABACUS transaction. 56.3 D. Some transactions are sufficiently complex that their costs outweigh their benefits In regard to (A), (B), and (C), these are all lessons learned. In regard to (A), Allen is particularly critical: he thinks the complexity of the transaction, since they “hadn’t been tailored to meet client needs,” was a deliberate aspect of the manipulation by Bankers’ Trust. In regard to (D), please note COMPLEXITY is fundamental to the case. However, Allen says the lesson was not that complex transactions should be avoided but rather that the scandal caused firms “to tighten up their procedures for dealing with customers, both in better controls on matching the degree of complexity of trades to the degree of financial sophistication of customers �” � so this is rather an issue of complexity with regard to client suitability. Discuss in forum here: http://www.bionicturtle.com/forum/threads/l1-t1-56-bankers-trust.3598/