Case QFA0102-07

February 18, 2007

Universidad Carlos III

ABN Amro and VaR1
Joop Van der Kamp was faced with an important decision. Was late afternoon in June
2005 and Mr. Van der Kamp was responsible for approving overnight positions that
exceeded established guidelines. He was the head of the Risk Management Committee
at ABN Amro and had just been informed that the banks foreign exchange group was
saddled with a significant pound sterling exposure. At 700 million, this position vastly
exceeded the 150 million daily maximum. Moreover, on a mark-to-market basis, it was
already showing a loss.
Van der Kamp had to decide whether to allow the position to remain as is overnight. To
quickly and substantially reduce the position would be very costly given current market
conditions. It would also lock in a significant loss. Another possibility was to try to
hedge the exposure with the use of options. This too, could prove costly but leave open
the possibility of making a profit if the sterling market were to rebound during the next
several days.
ABN Amro was a large Dutch institution engaged in a broad array of financial business
in institutional and retail markets worldwide. These included lending, deposit-taking,
investment and merchant banking, brokerage, insurance and asset management. In
recent years, some of the banks principal activities such as foreign exchange trading
and derivatives issuance accounted for a significant and growing portion of its revenues.
The foreign exchange group operated principally out of Rotterdam, aided in overnight
trading by the banks dealing rooms in New York and Singapore. The group traded
most currencies in at least medium size, and Euro, the Japanese yen and the U.S dollar
in very large size. In these latter currencies, the group focused on serving major
customers, presenting itself as being specially competent in trading in large volume.
The sterling position arose out of a trade between ABN and a German corporate client.
The client had recently collected on a 1000 million receivable, which it wished to
convert into Euros. It had indicated its desire to do the trade fairly quickly, given its
anxiety about the possible effects on the currency markets of new U.S. economic data to
be released during the upcoming week. The client would give the business to ABN if
the bank would do the trade on a principal basis at a reasonable price.
1

This case is the basis for class discussion rather than to illustrate either effective or ineffective handling
of an administrative situation.

In a principal trade, ABN would quote and guarantee a price in advance. Its gross profit
would be derived from the difference between the guaranteed price and the price at
which the trade actually would be executed. If the trade were done on a so-called
agency basis, ABN would be paid a commission and the client would bear the risk
associated with executing the trade.
Ordinarily, ABN would not bid for sterling on such a scale. It has less expertise in
sterling than currencies like Euro and the U.S. dollar, and sterling in any event tended to
be considerably less liquid than the major currencies. The typical interbank trade size
was about 50 million. Nevertheless, the foreign exchange group saw this as an
opportunity both to satisfy the needs of an important client and to enhance its stature in
the sterling market.
At around 08:00 London time, when the European currency markets were beginning to
open and the Asian markets were about to close, ABN traders were busy assessing the
depth of the sterling market. The sterling market was most liquid during London
morning hours, and least liquid overnight during Asian trading hours.
The information gleaned by the traders suggested that the sterling market would
continue the relatively calm pattern it has exhibited during last week. Expected market
volatility, as implied by the prices of one-month sterling put and call options, was
slightly lower than in recent days. These volatilities were around 10% for the
sterling/euro and 14% for the dollar/euro (Exhibit 1 give historical information relating
to the levels and volatility of the sterling/euro, dollar/euro and sterling/dollar).
Moreover ABN s traders had received indications of interest from a large U.S. bank to
buy as much as several hundred million pounds. They also had received indications of
interest from many other market makers to buy in smaller size. Finally the traders group
believed that the pound would strengthen in the near future.
The foreign exchange group concluded that the sterling position could be laid off
relatively easily. Moreover, if the bank had to hold some of the position for a few days,
it likely would profit if the pound strengthened as forecast.
Shortly after 9:00, ABN approached the client and enquired whether the bank would be
bidding competitively against other institutions. The client responded No, its just
you. ABN then offered the client 2.2356 / on the full position. The price was 50 pips
outside the current bid side of the market which was being quoted on Reuters screens as
2.2406/2.2413 (bid/offer) for small trades. The present 7 pip bid/ask spread was typical
for trades in the range of 10 to 20 million. (1 pip = 0.01 cent = 0.0001 ). Medium-tolarge corporate deals would sometimes go inside this spread, for example, when a dealer
was eager to get the business for its information value. The client accepted ABNs price,
and the deal was consummated.
ABN immediately moved to execute the trade as planned, attempting to sell the sterling
for euros. However, the sterling market suddenly seemed to have evaporated. The
price of sterling fell rapidly, as did liquidity. The U.S. bank still was willing to do
several hundred million pounds, but now at 350 pips below the price which ABN has
guaranteed the client. Moreover, market makers who had previously expressed interest
no longer were willing to buy in anything other than small size. Then a rumor surfaced
that a British conglomerate, engaged in takeover discussions with a German company,

would soon be entering the market to buy euros for sterling in significant quantities. The
rumor ultimately proved unfounded but further unsettled the market nevertheless.
ABN traders quickly laid off what they could on the U.S. bank (250 million) at a 350
pips loss (3.5 cents), and then spent the rest of then day attempting to get the remainder
done. The traders did their best, but to little avail. By late afternoon, they had managed
to do only an additional 50 million, leaving the bank with its current exposure of 700
million. Sterling now was being quoted on Reuters screens at a 10 pip spread:
2.2013/2.2023.
At 17:00, Mr. Van der Kamp, the head of the banks risk management group, was
apprised of the situation. His initial reaction was disbelief that this could have occurred,
and he indicated in the strongest terms that the problem should be solved immediately.
ABN used a value-at-risk methodology to quantify the risk exposures of individual
trading positions, as well as the combined positions of a particular trading desk or the
firms aggregate portfolio. It measured VaR as the 99th percentile worst-case outcome
that the position would have experienced on a one-day basis over the past three years.
The bank presently used VaR to set guidelines on maximum position sizes.
The approximately 3.5 cents movement in the / price had resulted in a total mark-tomarket loss of 34.5 million, made up of a realized loss of 10.5 million, and an
unrealized loss of 24, derived as shown in Exhibit 2. These figures contrasted starkly
with the one and ten-day VaR estimates on the maximum 150 million position allowed
in the guidelines. Over the last three years, the worst daily move in sterling had been 1.3%, for a one-day VaR of 4.4 million, and the worst 10-day move in sterling had
been -4.1%, for a ten day VaR of 13.8 million. The realized loss alone was more than
twice the banks VaR allowance for sterling. And the total mark-to-market loss was
more than twice the ten-day VaR. Finally, the total loss represented almost a months
worth of the banks typical revenues from foreign exchange trading.
Mr. Van der Kamp feared that to close out the position in the present circumstances
would result in losses potentially much greater than the present 34.5 million. On the
other hand, to keep the position overnight would expose the bank to the risk of further
adverse moves. A standard method of protecting against sever market moves was to
purchase out-of-the-money / put options. However, this market was in even worse
shape than the spot market. The options were bid in small size at prices that implied
expected market volatility of around 12% (Exhibit 3 gives theoretical options prices for
different strike prices and volatilities).
Another alternative was to try to reduce the riskiness of the position by taking offsetting
positions in currencies that were correlated with the /. The most liquid candidate was
the /$. Over the last three years, the correlation between the daily price changes of
these currencies had averaged 0.3 and had been as high as 0.75 earlier in the year. Most
recently, the correlation had been around 0.4 (see Exhibit 1 ). Since it was only midday in the U.S. markets, there still was ample liquidity available both in the dollar/euro
spot as well as dollar/euro options. The options were being quoted at implied volatilities
just under 14%.

Exhibit 1
Distribution of Daily Currency Movements
6/1/02 5/3/05
Volatility and Correlations are time-dependent
/
$/
Percentile
/$
Minimum
-4.01
-2.89
-4.19
1%
-1.44
-1.9
-2.25
5%
-0.83
-1.19
-1.26
10%
-0.61
-0.88
-0.82
25%
-0.3
-0.38
-0.37
50%
0
-0.01
0
75%
0.25
0.37
0.34
90%
0.51
0.83
0.82
95%
0.74
1.32
1.11
99%
1.29
1.99
1.99
Maximum
2.3
3.17
3.47
S.D. (daily)
0.52
0.74
0.74
S.D. (annual)
8.22
11.7
11.7
S.D. max
23.1
21.1
22.3
/ v $/
$/ v /$
Correlation / vs /$
0.3
0.29
-0.74
Max Corr
0.75
0.8
0.1

Exhibit 2
Calculation of realized and unrealized losses
Price(/)
Quantity(m) Value(m)
Traded
2.2006
300
660.18
Client
2.2356
300
670.68
Realized loss
10.5
Exposure
2.2013
700
1540.91
Client
2.2356
700
1564.92
Unrealized loss
24.01
Total loss
34.51

Exhibit 3
Theoretical (Black-Scholes) Prices of One-Month Currency Put Options
(Spot currency price = 100) (Strike: At-the-Money, Out-the-Money)
Volatility
8%
10%
12%
14%
16%

ATM 100
OTM 98
0.92
1.15
1.38
1.61
1.84

OTM 96
0.24
0.41
0.59
0.79
1.01

0.04
0.11
0.21
0.32
0.47

Assignment Questions
1. Describe basic points
2. What is the implied volatility and what is the difference with historical volatility
presented in Ex. 1?
3. What is the difference between realized and unrealized losses?
4. How much will cost to cover the position with options?
5. What options strategy would you suggest?
6. What are the pros and cons of using OTC options versus organized market
options?
7. To hedge the long position in you may take short positions in another
currencies provided there is a reasonable correlation in the movements of both
currencies. Do you think that this logic applies in this case?
8. What is your estimate of the correlation between exchange rates / and /$?
9. What hedging strategy would you suggest?