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Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Analyze the key factors that led to and derive the lessons learned from case studies involving the following risk factors: Model risk, including the Niederhoffer case, Long Term Capital Management and the London Whale case; Rogue trading and misleading reporting, including the Barings case; Financial engineering and complex derivatives, including Bankers Trust, the Orange County case, and Sachsen Landesbank


20.15.1. In early 2012, J.P. Morgan Chase (JPM) lost billions on trades executed by the London Whale, the notorious nickname for Bruno Iksil, who assumed massive exposures (masquerading as hedges) in a large credit derivative portfolio. Which of the following BEST summarizes the root cause of the debacle?

a. Lack of formal risk limits
b. A poor risk culture enabled by failures in corporate governance
c. The chief investment office (CIO) lacked the sophistication to correctly value certain credit derivatives
d. The chief investment office (CIO) used only one metric, value at risk (VaR), an over-reliance owing to JPM's pioneering use of VaR

20.15.2. In 1995 Baring Bank collapsed. Each of the following is a key lesson from the collapse EXCEPT which is false?

a. Leeson's arbitrage positions were valued with models that ignored risk factors and mis-specified correlations; aka, model risk
b. Outsized or strangely consistent profits (think Bernie Madoff as well) should be independently investigated and rigorously monitored
c. Reporting and monitoring of positions and risks (i.e., back-office operations) must be separated from trading (i.e., front-office operations)
d. If Basel's subsequent 1996 amendment had been in effect, Barings' downfall might have been avoided because Basel's concentration limits disallowed banks from taking positions that exceed 25% of their capital and also required them to report risks that exceed 10% of their capital

20.15.3. Case studies that feature financial engineering by way of complex derivatives include Bankers Trust, the Orange County case, and Sachsen Landesbank. In regard to these financial engineering cases, each of the following statements is true EXCEPT which is false?

a. Bankers Trust (BT) proposed an overly complex swap to their clients (P&G and Gibson Greetings) but the swaps experienced colossal losses; the clients sued BT, who never recovered from the ensuing reputational damage
b. Orange County's treasurer (Robert Citron) borrowed through the repo market to purchase inverse floating-rate notes--positions that Citron later said he did not understand--but the combination of excessive leverage and embedded interest-rate risk generated losses that ultimately forced Orange County to file for bankruptcy
c. Sachsen Landesbank set up off-balance-sheet vehicles (guaranteed by Sachsen) that held highly-rated U.S. mortgage-backed securities; the operation was highly profitable but the 2007-08 subprime crisis wiped out Sachsen's capital
d. If the purpose of the position is designated as hedging (rather than speculation) and if the hedge consists only of some combination(s) of forwards, swaps and/or options--which are the primary building blocks--then the firm can avoid problems suffered by the financial engineering case studies because the firm avoids undue sophistication

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