One ordinary day, I returned from a nice lunch in the summer sun to find a senior trader waiting beside my office. He looked a bit guilty.
He explained to me that he had been incorrectly marking his forward prices on certain purchase contracts to hide a loss. He insisted that he had been in a “living hell” for a while, since his position moved against him, and was “so sorry” that now, this would not only effect his future badly but also the reputation of my risk department. He was not wrong.
Fortunately, on this occasion, I had a culprit that could show us exactly what he had been doing to hide his loss.
He had purchased physical product in Europe in Euro and as a hedge, against the position risk, he had sold futures on both Matif and CME exchanges. The net risk was two fold. Firstly there was a volatile correlation between the physical and future prices that had not been reflected in his daily price adjustments and secondly, between the Euro physical position and CME futures there was a EURUSD foreign exchange risk.
Knowing the volatile nature of the price spread between the physical and futures market, the trader, when the spread started to go against him, set a fixed spread to mark his forward price and just maintained it.
A market risk department will flag a forward position if the price mark has not moved for a period of time but in this case it was moving each day. What was not picked up was the fact that it moved an identical amount to the futures price.
Eventually the market risk department noticed that new trades were being closed for a similar location and forward date by a different desk and at a price different to those of the marks in the offending book. When they had questioned the trader about his price marks, his explanation was multi faceted, about quality, load-rates, port spreads and other contractual terms. In this situation it is necessary for the risk department to discredit these reasons before calling foul. The trader knew this, knew they would do it and that his days were numbered. That is why he came to me and confessed.
There was a second component to the eventual loss and this was the foreign exchange position between the Euro physical long and USD futures short. The Euro exposure was known and treasury had been informed that this made sense because the product was being purchased in Euros and would subsequently be sold into a Euro destination. That may sound like a justification, but it is not. If you report in dollars then any non dollar exposure is just that. The correlation between exchange rates and non-dollar commodities does not, in my experience, justify a non reporting currency exposure.
Market risk departments should attempt to check mark to market prices daily for all forward open positions and where a reliable 3rd party price is not available then a study should be made of the spread to a correlated market which does have liquidity and so more reliable price marks. It is not enough to look at exchange prices to determine whether a related physical price mark is correct.
In an international trading company, spreadsheets are not sufficient for such tasks and a data strategy is required to provide necessary transparency and daily checks at a global, transaction level.
Foreign exchange should always be hedged unless there are specific limits which have been agreed and the exposure remains within that limit.
The outcome was a $9m loss and the trader was asked to leave the company.
It also promoted the budget for a better database solution for the risk department to more reliably check mark-to-market pricing on the trading desks.
No further action was taken.
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