Question:
For each of the following, try to name the single most significant risk factor and, similarly, try to identify the single alternative measure that might have prevented losses (operational or otherwise).
(i) Metallgesellschaft
(ii) Sumitomo
(iii) Long-Term Capital Management (LTCM)
(iv) Barings Bank
Answer:
Note: unlike an exam questions, this question allows for some subjectivity. There is not necessarily a single correct answer in each case.
(i) In regard to the single risk factor for the Metallgesellschaft case, arguably it starts with BASIS RISK. The stack-and-roll strategy entailed:
* Short positions in long-term forward contracts plus
* Stack-and-roll hedging with short-term futures contracts.
The oil curve shifted from backwardation to contango. Most of the others problems resulted from this. Accounting forced mark-to-market losses on the future hedges without offset gains on the forward contracts, which in turn triggered margin calls and a funding liquidity crisis (although the large positions also exhibited MARKET liquidity risk). Please note in the case of Metallgesellschaft,
* there was no fraud
* there was an economic flaw (basis risk) in the cash flows associated with the hedge, and
* additionally, the accounting created losses (market to market the futures hedges but not the underlying forwards)
It is hard to exactly name a single preventative measure. The case says, “it seems that management was directly responsible for the financial catastrophe. If managers had not taken such a large position in long futures, or if they had at least used put options as a hedge for their position, then the magnitude of the cash flow problem could have been reduced.”
(ii) In the case of Sumitomo, Hamanaka was cornering the copper market in a plan of “outright fraud and illegal trading practice.”
The key preventative measure was “proper internal control measures as well as better portfolio diversification to protect against downside risk.” The lack of internal control included: lack of management supervision, lack of risk management, and failure to control the market.
(iii) “The event trigger for the LTCM crisis was MODEL risk.” In particular, LTCM’s risk management model “relied too heavily on the bell-shaped normal distribution curve” and their signature trade “known as equity volatility, comes straight from the Black-Scholes model. It is based on the assumption of constant volatility.”
In regard to prevention at LTCM, one could make several different arguments. But arguably the key measure would have been more comprehensive and rigorous STRESS TESTING (rather than their leaning on “theoretical models"); e.g, stress testing changes in market risk with greater volume, stress testing credit risk scenarios.
(iv) Leeson is the classic “rogue trader” so, not totally unlike Sumitomo, the key cause is an OPERATIONAL RISK factor; i.e., “the regulatory, supervisory, and corporate governance framework failed completely.” The preventions concern better internal risk controls; i.e., standards for traders, better information systems, separation of settlement/trading, and management oversight.
. But okay, I have posted mine now...David
