2 instrument valuation for each simulation date and

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2. Instrument Valuation . For each simulation date and for each realization of the underlying market risk factors, instrument valuation is performed for each trade in the counterparty portfolio. 3. Portfolio Aggregation. For each simulation date and for each realization of the underlying market risk factors, counterparty-level exposure is obtained by applying netting rules. Fin330 15
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3. Risk must be quantified and risk limits set Fin330 16
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Case of Barings Bank l During 1992-95, Nicholas Leeson was the chief derivatives trader in Singapore’s office of the Barings bank (UK). l His trade operations caused a loss of 1 billion dollars and eventually destroyed the 200 year old bank. Fin330 17
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Case of Barings Bank l His main assignment was to arbitrage on the Nikkei 225 futures between SIMEX and OSE. l In reality he was taking speculative positions. l At one point Leeson had 20,000 futures contracts worth over $3 billion on the Nikkei. l He was financing SIMEX’ margin requirements by short-selling Nikkei 225 straddles and borrowing money from the Barings bank. Fin330 18
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Case of Barings Bank Fin330 19 l A straddle is created by selling a call and a put with the same strike price K and time to expiration T .
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Payoffs and Profits at Expiration: Short a Call Payoff , Profit S T Profit = -max(S T -K,0) + FV(c) > = K S if 0 K S if ) K S ( Payoff T T T K Fin330 20
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Profit = -max(K-S T ,0) + FV(P 0 ) Payoffs and Profits at Expiration: Short a Put < = K S if 0 K S if ) S K ( Payoff T T T Payoff , Profit S T K pe rT – K pe rT Fin330 21
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Case of Baring Bank l In 1993, he made £10 millions (10% of the bank’s profits for that year). l On January 17,1995, a violent earthquake hit Kobe. Nikkei fell 1,500 points. l The discovery of a secret file – “ Error Account 88888 ” – showed that Leeson had gambled away ca. 1 billions dollars in Barings’s name.
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