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

A trading desk reports cumulative profit with very low volatility and a high Sharpe ratio, but its funding requests from head office keep rising and the positions are said to be 'market-neutral arbitrage.' Which interpretation is most consistent with lessons from Barings and Allied Irish Banks?

Unusually smooth profits combined with rising funding needs, inconsistent with a supposedly low-risk arbitrage strategy, are red flags. Management should independently verify positions, cash flows and valuations rather than trust self-reported results, as the Barings and Allied Irish Banks cases showed.

  1. AThe results are likely credible, because low volatility indicates effective hedging
  2. BReturns inconsistent with the stated low-risk strategy and rising funding needs are red flags requiring independent verification of positions and cash flowsCorrect
  3. CFunding requests are irrelevant to risk assessment of a trading desk
  4. DOnly the trader's self-reported valuation needs to be reviewed annually

Explanation

At Barings, reported arbitrage profits did not match the low risk claimed and funding needs grew. Such inconsistencies call for independent reconciliation of positions, cash and valuations. Accepting results on trust is the failure seen in these cases.

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