FINANCIAL DISASTERS
FRAUD
DISASTER DUE TO MISLEADING REPORTING
VALUATION ISSUES
JDNKJN
1. Chase Manhattan vs
Drysdale Securities
INCIDENT-
-Drysdale borrowed T-
securities from sec dealer
through Chase Manhattan,
indulged in arbitrage by short
selling US Treasuries for Mkt
Price+ Acc Int in Govt sec Mkt
& borrowing US treasuries at
MkT Price In Repo Mkt.
Collateral valuation
- resulting in huge
was made without Acc
interest. Mkt rallied,brought
huge losses & Chase had to
bear coupon payments on
behalf of Drysdale.
LESSONS LEARNT-
Rules for collateral valuation
& Risk Control Functions.
2. Kidder Peabody
INCIDENT-
rt
-Value of Fwd Contract=Se -S
IGNORED
PRICING OF
WRONG
FORWARDS.
INSTANT PROFIT RECORDED
-S/Holders lost confidence in
company; no cash loss.
LESSONS LEARNT-
Investigate unexpected profits
& review models.
3.UNION BANK OF
SWITZERLAND (UBS)
INCIDENT-
-Concentration Risk ( LARGE
STAKE IN LCM).
-Unusual Independence to
Derivatives Division.
-Low realization while selling
Basket of Equity
Long Dated
options,but not apparent due
to usage of Marked to Model
feature.
-Inappropriate hedging of
Bank Warrants
-British Tax Law Changes
LESSONS LEARNT-
Separate risk mgmt
department
& correct model for
valuations.
NO FRAUD DISASTER DUE TO
CUSTOMER BUSINESS
DISASTER DUE TO LARGE
MARKET MOVES
IMAGINARY TRADES Trust
HOARDING
Bankers
1.Barings Bank Sumitomo 1.LTCM
INCIDENT- INCIDENT- INCIDENT-
INCIDENT-
- For Interexchange S+,F+ -On being approached by
-Hedge Fund developed by Scholes &
arbitrage using Nikkei -Bought all P&G & Gibson for a
Merton
Futures,used Short physical derivative trade that would
-Indulged in relative value trades-sold
Straddle i.e.(P-,C-) & commodities reduce their funding cost,
D the run & bought off the run
on
Long Futures on both along with their Bankers Trust presented
securities due to contrarian view.
the Index( 2F+). futures. their strategy in such a
-Due to Kobe -Heavy losses due C
- onvergence strategies- complex manner that
earthquake, Nikke to liquidity Went long on Russian sovereign P&G & Gibson could not
futures fell & risk.Impact loss securities,had a view that their risk understand.
high.
volatility increased has been overestimated,which on -No competitive quote –A
correction will result in lower feeling of tailor-made
losses. yield.But Ruble crisis resulted in flight strategy.
-Changed software to to quality,widening the spread . -Tapped phone
not report trades,since Sold options expecting mean conversations showed how
head of front & back reversion of volatility,BUT it shot up. Bankers Trust STAFF
office same. FOOLED THEIR CLIENTS.
-Warning signals like M
- odel Risk-Based on historical -Lost customers’
data & lot of assumptions
Trust.Reputational Loss.
unexpected profits in
imaginary
trades(changed
T
- ail Risk not captured .
software) & margin
call outflow bcoz of
-Liquidity –Did not have liquidity LESSONS LEARNT-
when margin calls trigerred. -Complex strategies are
exchange trade possible but should be
feature. communicated
LESSONS LEARNT- understanding the
LESSONS LEARNT-
Independent trading Better use of stress tests in assessing sophistication level of
office & inquire credit risks,need for initial margin if client.
unexpected profits & counterparty’s principal business is -Customers should be able
sources of cash. trading,need to incorporate to obtain price quotes
endogenous & exogenous liquidity from an area independent
I
2.Allied rish Bank
risks. of front office.
-Firms should be cautious
INCIDENT- 2 Metallgesellschaft of communications .
-For arbitrage using FX
options,indulged in
speculation.
INCIDENT-
SDFSDF
Entered into a 5 yr Fwd contract to
-VAR under-reported. sell heating oil to customers.Ran the
-Bullied back office risk of price going up,due to which it
employees. entered into short dated futures &
-Sold options to show decided to roll them over-[This
high cash flows in the resulted into huge losses.]
OTC Market & only Reasons-
modest gains  Oil prices fell-Loss in futures
reported.
position & gain in F/w
position.
 Market for oil changed from
backwardation to contango.
 Futures loss resulted in cash
outflow on futures position
but no cash inflow in fwd
gain leading to liquidty
problem.
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