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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

A bank's rogue trader hides a loss by booking a fictitious option, exploiting the fact that the option is valued using a trader-supplied volatility that the middle office does not check. Which control would most directly address this specific weakness, as emphasized by the Allied Irish Banks (Allfirst) case?

Independent price verification of option values and inputs, together with counterparty confirmation of trades, addresses the weakness. At Allfirst, fictitious options and unchecked trader-supplied valuation inputs hid losses. Bonus deferral or a higher VaR confidence level would not reveal fake trades or mispriced positions.

  1. AIncreasing the trader's bonus deferral period
  2. BIndependent price verification of option valuations and inputs, including confirmation of trades with counterpartiesCorrect
  3. CRaising the VaR confidence level from 95% to 99%
  4. DRotating the trader's desk seating arrangements

Explanation

At Allfirst, fake options were used to hide losses and valuation inputs were not independently checked. Independent price verification and counterparty confirmations directly test whether trades exist and are valued properly. Bonus deferral and VaR level do not address fictitious trades or unchecked inputs.

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