FRM Fun 5

[Suzanne Evans]

FRM Fun 5.

In what will probably appear as a future FRM case study, JPMorgan Chase recently disclosed that losses on its now infamous trade might reach up to $9 billion. Wikipedia has a good entry summarizing the current, known facts at http://en.wikipedia.org/wiki/2012_JPMorgan_Chase_trading_loss. And Felix Salmon has written several informative blog entries, see http://seekingalpha.com/author/felix-salmon/articles/symbol/jpm.

The FRM tends to categorize historical risk (case study) disasters according to the key risk(s) that manifested; e.g., Bankers Trust was due to "material misrepresentations and omissions to clients." If we must try to compare JPMorgan to just one infamous FRM case study, which case is MOST SIMILAR with respect to the key risk that manifested? (and briefly justify your answer please):

• Banker's Trust/P&G
• Barings
• Kidder Peabody
• LTCM
• Metallgesellschaft
• Sumitomo

 

[Aleksander Hansen]

I would say LTCM as this pertain to

1. Sovereign defaults or risk thereof, albeit LTCM were not trying to profit from this or hedge the exposure, but a common underlying risk was sovereign risk
2. Flight-to-safety
3. Flight-to-liquidity
4. In both cases management were aware of the positions, and red flags has been raised in the case of LTCM and to a certain extent JPM; management nevertheless chose to ignore, or not hedge or unwind their exposure.
5. JPM claim this was a hedge, but one could argue that this was really a bet on convergence, much like LTCM's convergence arbitrage trades.
6. Both companies employed relatively advanced strategies, whereas the other list of companies here were doing very basic stuff, and captures only part of the story.

... besides, it sounds like a lot of money, but it's been blown completely out of proportion. A $2-$4bn loss is actually not unreasonable. Looking [and blaming] the risk oversight committee at JPM makes no sense whatsoever; a risk oversight committee do not monitor individual trades.
As for LTCM they got squeezed on liquidity, but their trades/positions ultimately turned out to be profitable.

 

[David Harper CFA FRM]

Hi Alex,

Thanks for a great answer (although apologies I don't quite understand the "flight to safety" in the context of JP Morgan?)!

On a more superficial level, I was also thinking Metallgesellschaft (MG) and basis risk: MG was rolling futures and generating profits on the ostensible and ongoing "hedge" (i.e., a stack and roll hedge that for a long time had a positive expected return in oil backwardation, so it retrospect didn't look like a hedge. Or that's how i tend to think of a hedge: as having negative expected NPV) and the hedge failed on switch to backwardation. Since JPMorgan's hedge (CDS trade #1 and #2) failed, on a really superficial level I initially thought basis risk on the simple point that both involved the failure/loss on the *ostensible* hedge which arguably wasn't really a hedge. No right/wrong answer of course ...

Thanks,

 

[Aleksander Hansen]

Flight to safety due to European turmoil, slowing Asian economy and poor numbers out of the US --> US, German and Swiss Bonds attractive. US corporations less so, causing the trades to sour as a large part was tied to long CDS on IG9, which suffered when corporate credit seemed less secure, a lot of uncertainty causing people to pull out or go long Treasury Bills, Notes and Bonds.

 

[Aleksander Hansen]

My bet is we'll see some Fed action, which will temporarily boost equities and increase yields as people re-allocate from Treasuries. European situation wil persist so markets will still be jittery, but derivatives on vol indexes such as VIX will come down, but will fluctuate. Vols and VIX back up as we approach debt ceiling and the clowns in congress try to be clever. If situation persists and stimulus and deficit spending continues, slide back into a double-dip. Problems also will arise with inflationary pressures considering the unprecedented growth in the Feds balance sheet will force money hitting M0, M1, M2, and M3 through the monetary channels and intermediation. Already seeing signs of too much money chasing too few resources.

 

[Mohamed Sakr]

I see it very similar to Barings, taking positions in derivatives and betting on the underlying. Nick Leeson did it with Nikkei futures and JPM misused CDSs.

It is also similar to Metallgesellschaft (Selling long-term protection for short-term protection bought), betting that investment grade bonds will not default just like when Metallgesellschaft assumed that the oil market will remain in backwardation.

It is also similar to the UBS $2 Billion loss last year (and Barings too), when a trader covers his loss by taking a larger position in the same asset at a better price, and the asset continues making losses (effectively amplifying losses).