Book 1. Foundations of Risk Management

FRM Part 1

FRM 9. Learning from Financial Disasters

Presented by: Sudhanshu

Module 1. Case Studies on Interest Rate Risk, Liquidity Risk and Hedging Strategy

Module 2. Case Studies on Model Risk and Rogue Trading

Module 3. Case Studies on Financial  Engineering, Reputation Risk, Corporate Governance and Cyber Risk

Module 1. Case Studies on Interest Rate Risk, Liquidity Risk and Hedging Strategy

Topic 1. Interest Rate Risk

Topic 2. Liquidity Risk

Topic 3. Northern Rock

Topic 4. Lessons from Liquidity-Linked Crises

Topic 5. Hedging Strategies

Topic 6. Hedging Case – Metallgesellschaft

Topic 1. Interest Rate Risk

• Definition: Interest rate risk is the risk of loss from unexpected changes in interest rates, especially when there's a mismatch between the maturities of assets and liabilities.​
• Savings & Loan Crisis (1980s, U.S.):
  • S&Ls borrowed short-term (deposits) and lent long-term (fixed-rate mortgages).
  • Regulation Q capped deposit rates, allowing S&Ls to profit from the yield curve initially.
  • High inflation in late 1970s led to steep rate hikes by the Fed.
  • This inverted the spread: cost of funds > return on loans.
  • Impact: 35% of S&Ls failed; $160 billion taxpayer-funded bailout.
• Risk Mitigation Tools:
  • ​Duration Matching: Align durations of liabilities and assets.
  • Derivatives: Interest rate swaps, floors, and caps to offset rate movements.

Practice Questions: Q1

Q1. Which of the following methods is not a way in which banks can mitigate interest rate risk?

A. Use swaps.

B. Use floors and caps.

C. Extend loan assets to longer terms.

D. Match the duration of the bank’s assets and liabilities.

Practice Questions: Q1 Answer

Explanation: C is correct.

The S&L crisis highlighted the very real impact that unmanaged interest rate risk can have on a firm and an industry. Banks can mitigate their interest rate risk through duration matching between assets and liabilities and through the use of derivatives such as caps, floors, and swaps. Extending loans to longer terms would only increase the duration of the bank’s assets and would therefore make the interest rate risk issue worse.

Topic 2. Liquidity Risk

• Definition: The inability to meet short-term obligations due to lack of cash or liquid assets.​
• Causes:
  • Funding long-term, illiquid assets with short-term borrowings.
  • Market disruptions reducing access to short-term funding.
• ​Key Metrics: Liquidity coverage ratio (LCR), net stable funding ratio (NSFR).
• Implications: Asset fire sales, credit rating downgrades, insolvency.

Topic 3. Northern Rock

• Business Model: Aggressively grew its mortgage book using short-term wholesale funding.​

• Unique Features:
  • Operated on an Originate-to-Distribute (OTD) model.
  • Relied on global short-term markets (U.S., Europe, Asia).
  • Received a Basel II waiver, allowing higher dividends, reducing retained capital.
• ​Trigger: Rising mortgage defaults globally triggered fear among creditors.
• Bank Run:
  • ​Leaked news of Bank of England support led to panic.
  • Withdrawal of deposits forced the bank into insolvency.
• Withdrawal of deposits forced the bank into insolvency.
• Lesson: Liquidity buffers and diversified funding sources are critical.

Topic 4. Lessons from Liquidity-Linked Crises

• Key Takeaways:
  • Regulatory stress tests now standard for major banks.
  • Asset-Liability Management (ALM) must balance duration and funding risk.
• ​Tradeoffs:
  • Reducing interest rate risk can increase liquidity risk and vice versa.
  • Using long-term funding sources improves liquidity but raises cost of capital.
• Emergency Planning:
  • ​Credit lines with counterparties.
  • Central bank access in crisis situations.
  • Maintaining high-quality liquid assets (HQLA).

Practice Questions: Q2

Q2. How is liquidity risk dangerous for a bank?

A. Liquidity risk positively correlates with interest rate risk.

B. Liquidity risk results from using costly long-term funding sources.

C. When long-term assets are funded with short-term liabilities, trouble is waiting if the funding sources evaporate.

D. When long-term liabilities are funded with short-term assets, trouble is waiting if the funding sources evaporate.

Practice Questions: Q2 Answer

Explanation: C is correct.

Liquidity risk is most dangerous when long-term assets (i.e., loans) are funded with short-term liabilities (i.e., funding sources). Liquidity risk can be mitigated by (not result from) using costly long-term funding source. With asset/liability management (ALM), liquidity risk and interest rate risk are inverses.

Topic 5. Hedging Strategies

• Why Hedge? To protect financial performance from adverse market movements.​
• Types of Hedging:​
  • Static Hedging:
    • One-time hedge set for the investment horizon.
    • Low cost, minimal maintenance.
    • Does not adjust to changing market conditions.
  • Emergency Planning:
    • ​Frequent rebalancing based on market conditions.
    • More accurate but involves higher costs and model dependency.
    • Can magnify liquidity and operational risk.

Topic 6. Hedging Case – Metallgesellschaft

• Company: MGRM offered long-term fixed-price contracts on petroleum products.​
• Hedge: Used a stack-and-roll strategy:
  • ​Long positions in short-term futures (monthly contracts).
  • Hedged short exposure from long-term fixed-price contracts.​
• Market Condition: Oil prices fell, resulting in contango.
• Impact:
  • Large unrealized losses due to rolling forward futures at a higher price.
  • Margin calls led to a liquidity crisis.
• Fundamental Issue: Timing mismatch—gains on customer contracts were long-term, but losses on futures were marked-to-market daily.
• Lessons:
  • ​Rolling hedges require cash flow management.
  • Accounting and tax rules can distort financial reporting.
  • Proper contingency funding is critical for dynamic hedging.

Practice Questions: Q3

Q3. Which of the following statements is correct regarding the implementation of a hedging strategy?

A. Dynamic hedges require active supervision.

B. Dynamic hedges require the use of one-month futures contracts.

C. Static hedges are the best option for a rapidly changing market environment.

D. Static hedges require that the hedging instrument exactly match the position to be hedged.

Practice Questions: Q3 Answer

Explanation: A is correct.

Dynamic hedging strategies are the best options for rapidly changing market environments. However, they require active supervision and will incur higher transaction costs than their static counterparts. A dynamic hedge uses short-term contracts, but there is no requirement that contracts must be monthly in tenure.
A static hedging strategy involves buying a hedging instrument that closely matches the position to be hedged.

Module 2. Case Studies on Model Risk and Rogue Trading

Topic 1. Model Risk

Topic 2. Niederhoffer Case

Topic 3. LTCM – Long-Term Capital Management

Topic 4. The London Whale Trade

Topic 5. Rogue Trading – Barings Bank

Topic 1. Model Risk

• Definition: The risk of financial loss due to errors in financial models.

• Sources:

  • ​Using incorrect or oversimplified models.

  • Poor assumptions, e.g., normal distributions or historical volatilities.

  • Lack of stress testing for extreme scenarios.

• Implications: Leads to underestimation of risk and poor strategic decisions.

Topic 2. Niederhoffer Case

• Strategy: Sold deep out-of-the-money (OTM) S&P 500 put options.

• Assumption: Daily declines >5% were highly unlikely.

• Reality: 1997 Asian financial crisis caused a 7% drop in one day.

• Impact: $50 million margin call wiped out the fund.

• Lesson:

  • Tail risks are real—don't rely only on historical volatility.

  • Risk must be assessed under stress and extreme scenarios.

Topic 3. LTCM – Long-Term Capital Management

• Founders: Nobel laureates, ex-central bankers, top traders.

• Strategy: Leveraged relative value arbitrage (e.g., bond spread trades).

• Leverage: 25:1 on balance sheet; over $1 trillion in notional exposure.

• Crisis:

  •  Russia defaulted (1998), triggering a flight to quality.

  • LTCM’s short positions (e.g., U.S. Treasuries) spiked in value.

  • Over $2 billion in losses in a month.

• Fed-led Bailout: Avoided systemic collapse.

• Lessons:

  • VaR models with short horizons are inadequate.

  • High leverage demands strong liquidity management.

  • Assumptions fail in crises—stress test comprehensively.

Practice Questions: Q4

Q4. Which of the following statements is not a lesson that risk managers should learn from the Long-Term Capital Management case study?

A. Short-term VaR parameters are always the best risk management tool.
B. There should be no exceptions to initial margin requirements imposed by lenders.
C. Position liquidity should be carefully monitored, especially when using extreme leverage.
D. Correlations are a great way to consider asset allocation, but they need to be monitored for convergence during periods of stress.

Practice Questions: Q4 Answer

Explanation: A is correct.

LTCM relied heavily on value-at-risk (VaR) modeling using a 10-day time horizon.
A 10-day horizon is far too short a window to survive a short-term market shock.

Topic 4.The London Whale Trade

• Trader: Bruno Iksil (JPMorgan CIO's London Office).

• Issue:

  • CIO tried to offset losses by doubling down on risky credit derivatives.

  • Used non-standard valuation methods to reduce apparent losses.

• Breach: Over 330 risk limit violations ignored or manipulated.

• Losses: $6.2 billion and regulatory penalties.

• Lesson:

  • Risk models must be applied consistently and independently.

  • Internal controls must not be overridden for short-term optics.

Topic 5. Rogue Trading – Barings Bank

• Trader: Nick Leeson controlled both trading and back-office.

• Fraud:

  • Used a hidden account to cover losses.

  • Took unauthorized directional bets on Nikkei futures.

• Collapse: £827 million in losses; bank sold for £1.

• Lesson:

  • Front-office must not oversee back-office.

  • Independent verification of results is critical.

  • Large, unexplained profits require deeper scrutiny.

Practice Questions: Q5

Q5. Which of the following actions is not a step that could help prevent a rogue trader from destroying an entire business?

A. Maintain separation between supervision of back-office and front-office operations.
B. Treat all expectation-beating results with a degree of healthy skepticism.
C. Monitor trading profits that are reported to be consistent over time.
D. Measure all trading activity over short periods of time and not over the tenure of the trade.

Practice Questions: Q5 Answer

Explanation: D is correct.

The Barings Bank case study highlights the need to separate supervision of the back-office and the front-office. Any trading profit that appears too good to be true or is strangely consistent over time should be treated with a healthy degree of skepticism. Rogue traders can sometimes try to hide economic reality by reporting performance only over favorable time periods. Management should consider the ultimate outcome of each aggregate strategy and not isolated time periods.

Module 3. Case Studies on Financial  Engineering, Reputation Risk, Corporate Governance and Cyber Risk

Topic 1. Financial Engineering

Topic 2. Bankers Trust

Topic 3. Orange County

Topic 4. Sachsen Landesbank

Topic 5. Reputation Risk

Topic 6. Volkswagen Emissions Scandal

Topic 7. Corporate Governance – Enron

Topic 8. Cyber Risk

Topic 9. The SWIFT Case

Topic 1. Financial Engineering

• Tools: Derivatives like forwards, swaps, options, securitizations.

• Purpose: Used to hedge risks or (mis)used to enhance returns

• Risk: Misunderstanding or over-leveraging these tools leads to disasters.

• Governance: Requires deep understanding, transparency, and audit controls.

Topic 2. Bankers Trust

• Client: Procter & Gamble (P&G) entered into leveraged interest rate swaps.

• Mistake: Used complex swaps to speculate on falling rates.

• Rates rose: Fed hiked rates in 1994—losses magnified due to leverage.

• P&G sued: Won $78 million; BT reputation destroyed.

• Lesson:

  • Clients must understand instruments.

  • Never speculate under the guise of hedging.

Topic 3. Orange County

• Treasurer: Robert Citron used repo borrowing + inverse floaters.

• Strategy: Leveraged $20B to earn 2% higher than peers.

• Collapse:

  • Fed rate hikes reduced coupon payments.

  • Investors stopped rolling repo contracts.

  • County filed for bankruptcy.

• Lesson:

  • Don't invest in what you don't understand.

  • Repos and structured products carry refinancing and complexity risk.

Topic 4. Sachsen Landesbank

• Profile: German public bank focused on regional lending.

• Problem: Invested in U.S. subprime via offshore vehicles.

• Crisis: Suffered huge losses; forced to merge with a more conservative bank

• Lesson:

  • Securitized investments must be properly assessed for risk.

  • Off-balance sheet exposure is still real risk.

Topic 5. Reputation Risk

• Definition: Damage to firm’s image can hurt operations and valuation.

• Sources:

  • ESG violations, fraud, customer mistreatment.

  • Media amplification worsens even small events.

• Consequences: Regulatory scrutiny, customer flight, investor panic.

Topic 6. Volkswagen Emissions Scandal

• Issue: Cheated emissions tests using software manipulation.

• Impact:

  • 10 million cars affected.

  • Stock price fell by 33%.

  • Billions in fines and legal costs.

• Lesson:

  • Ethics matter: fraud can destroy brand value.

  • ESG practices must be authentic and transparent.

Practice Questions: Q6

Q6. Which of the following scenarios most likely presents a reputation risk?
A. The CFO of a regional bank announced that it is using financial engineering to manage risk.
B. A risk manager buys one asset and sells another in an attempt to capture a perceived mispricing between the two assets.
C. A regional manufacturer is rumored to be replacing all plastic packaging with biodegradable and recycled products.
D. The unmonitored equipment of an electric utility is rumored to be the cause of a series of wildfires that caused significant damage.

Practice Questions: Q6 Answer

Explanation: D is correct.

A rumored environmental issue will impact stakeholders as a result of reputation risk. Replacing packaging with sustainable sources does impact reputation, but it is not a risk element because it should cause reputational gain and not reputational loss for the firm involved. Attempts to hedge risk would not be considered a reputation risk unless there was an accounting fraud issue.

Topic 7. Corporate Governance – Enron

• Failures:

  • ​Chairman = CEO (Ken Lay).

  • CFO ran personal equity firm managing company funds.

  • Used SPVs to hide debt; fake sales to inflate revenue.

• Auditor: Arthur Andersen complicit; collapsed with Enron.

• Outcome: Enron bankruptcy led to Sarbanes-Oxley Act (2002).

• Lesson:

  • Governance requires independent oversight.
  • Transparency and accountability are critical.

Practice Questions: Q7

Q7. Which of the following statements is not a lesson learned from the collapse of Enron?
A. Independent and ethical auditors are needed as a double check to mitigate agency risk.
B. The roles of chairman of the board and CEO should be separated for enhanced accountability.
C. The best way for a company to avoid fraud is for the CEO and the CFO to be in constant contact regarding internal policies.
D. Aggressive accounting techniques should be highly scrutinized by investors, or the target company should be avoided as a potential investment.

Practice Questions: Q7 Answer

Explanation: C is correct.

From the Enron scandal, we have learned the importance of separating the roles of the chairman of the board and the CEO. The board should be providing supervision and oversight of management’s policy and not leave oversight to only the CEO and the CFO. Aggressive accounting techniques should be avoided and
scrutinized if discovered. The role of an independent auditor is to keep management accountable and not to approve management’s policies to collect a fee.

Topic 8. Cyber Risk

• Definition: Risk of financial loss or reputational damage from cyberattacks.

• Attack Types:

  • ​Data breaches (PII theft), ransomware, phishing.

  • Financial fraud (fund transfer manipulation).

• Response:

  • Invest in cybersecurity.

  • Use third-party insurance and testing.

  • Regulatory compliance (GDPR, RBI, etc.).

Topic 9. The SWIFT Case

• Attack: 2016 hackers stole $81 million from Bangladesh Bank.

• Method:

  • ​Used stolen employee credentials to submit fake SWIFT requests.

  • Malware disabled notifications, covered tracks.

  • Caught only due to typo (“fandations”).

• Lesson:

  • Human and system safeguards are both critical.

  • Cybersecurity is a core operational risk, not just IT’s problem.

Practice Questions: Q8

Q8. Which of the following statements is correct regarding cyber risk?
A. Cyber risk is only a danger for banks.
B. Cyber risk must be retained and mitigated with internal resources.
C. Cyber risk is becoming less of an issue due to the impact of regulation.
D. Cyber risk involves the potential for loss resulting from a technology-related breach.

Practice Questions: Q8 Answer

Explanation: D is correct.

At its core, cyber risk is the risk of financial or reputational loss due to a breach of internal technology infrastructure. The importance of cyber risk is only growing as technology and digital money transfer are increasingly in use. This is a risk carried by any firm that transacts digitally, and firms can either address these concerns internally, hire an external IT consultant, and/or purchase cyber
insurance to outsource the risk.