Allen, Financial Risk Management: A Practitioner s Guide to Managing Market & Credit Risk

Transcription

1 P1.T1. Foundations of Risk Bionic Turtle FRM Practice Questions Reading 4 Allen, Financial Risk Management: A Practitioner s Guide to Managing Market & Credit Risk By David Harper, CFA FRM CIPM

2 KEY IDEAS... 3 ALLEN, CHAPTER 4: FINANCIAL DISASTERS... 4 P1.T1.50. CHASE MANHATTAN BANK/DRYSDALE SECURITIES

3 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 direct financial loss to the firm, but were a matter of reputational risk due to the conduct of customer business. Misleading Reporting Chase/Drysdale Kidder Peabody Barings Allied Irish Bank Union bank of Switzerland (UBS) Société Générale Unexpected market moves LTCM Metallgesellschaft Conduct of Customer Business Banker s Trust JPMorgan Citigroup Enron 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 high prevalence of operational risk, including its various risk subclasses Please be mindful of the difference between outright fraud (e.g., Leeson at Barings) and non-fraud: neither LTCM nor Metallgesellschaft involved deception 3

4 Allen, Chapter 4: Financial Disasters 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 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 4

5 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 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 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: Miller on Drysdale, Selected Points: Incident: In three months of 1976, Drysdale Government Securities, a newly founded subsidiary of an established firm, succeeded in obtaining unsecured borrowing of about $300 million by exploiting a flaw in the market practices for computing the value of U.S. government bond collateral. This unsecured borrowing exceeded any amount Drysdale would have been approved for, given that the firm had only $20 million in capital. Drysdale used the borrowed money to take outright positions in bond markets. When the traders lost money on the positions they put on, they lacked cash with which to pay back their borrowings. Drysdale went bankrupt, losing virtually all of the $300 million in unsecured borrowings. Chase Manhattan absorbed almost all of these losses because it had brokered most of Drysdale s securities borrowings. Although Chase employees believed they were only acting as agents on these transactions and were not taking any direct risk on behalf of Chase, the legal documentation of the securities borrowings did not support their claim Lessons Learned: 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 that 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. 5