Risk Latte - Risk Management Crisis in the FX Options Market

Risk Management Crisis in the FX Options Market

Team Latte
Jan 13, 2004


National Bank of Australia, the country's biggest bank, said on Tuesday it faced losses of up to A$180 million ($141 million) after uncovering unauthorized foreign exchange option trading, reports Reuters from Sydney adding that the losses related to trading in Australian and New Zealand dollar foreign exchange options. (See detailed Reuters' news or check with the markets news).

What really happened? - Butterflies and Convexity Risks in AUD/USD Options market:
The Bank had been selling 25-delta and 10-delta butterflies at below market prices for a long time. A butterfly is a spread of the ATM (at-the-money) straddle against out of the money calls and puts done on a vega adjusted basis such that the net vega is zero at the time of trade. Usually the out of the money (10/25 delta) calls and puts are priced higher than ATM (50 delta) calls or puts. This is because of the smile built in the volatility surface, which prices in the extreme movements of financial assets due to panic buying or selling. (Another reason for the smile is that empirically it has been found that financial assets distribution do follow the log-normal distribution curve, but with fatter tails (kurtosis), due to extreme movements). As the out of the money strikes are priced higher, whenever one sells a butterfly, one earns the volatility spread. Proper risk management procedure ensures that all the options in a portfolio should be evaluated with the smile, however some banks do not follow. This bank was evaluating without the smile (author's assumption), hence whenever the traders were selling butterflies, they were buying the ATM straddles and selling the out of the money puts and calls at a higher volatility, however the evaluation was done at the same volatility, which resulted in mark-to-market profit. Of course, this was a further motivation to continue.

Interestingly, when spot moves either way, such structure becomes short volatility very fast. If you notice the AUD/USD spot movement last 6 months, it moved from 0.65 to 0.78, a record 20 percent appreciation (annualized returns around 40 percent). The butterflies they sold 6 months ago, did not have any vega exposure at the time of the trade, however with spot higher the structure has become short vega now. To add to the misery, selling a butterfly causes one to sell convexity. And if one is short convexity, then higher volatility will make one shorter vega. With spot moving rapidly higher, the volatility getting paid much higher, and the bank is caught short enormous amount of vega, which is much above limits. Hence they had to stop buy huge amounts of volatility in the market. The top management came to know of the problem last night and since last night till this morning they were closing their position by buying volatility in the market pushing the 1yr volatility from 10.5 to 11.0. Market reported they bought a bit over a billion USD of vega in the last 24 hours. The net loss for the bank was reported to be 141 million USD, but I will not be surprised if it is much more. This is biggest risk management crisis since the Allied-Irish Bank scandal last year.


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