Risk Latte - Losses at UBS - Failed Risk Reversal Bets

Losses at UBS - Failed Risk Reversal Bets

Rahul Bhattacharya
Feb 14, 2005

In 1997 UBS lost between $400 million to $700 million in trading equity derivatives (of course the losses were exacerbated by lack of internal controls). Though the true nature of the trades and the resultant losses from those individual trades may never be known some reports indicate that one of the major categories of the trades on which the bank lost money was on "Risk Reversals" trades on Japanese equity warrants.

It is rumored that the bank was buying warrants on equities of Japanese banks and these warrants had the price-volatility profile of risk reversals. The warrant buyer had a positive vega and convexity at the prevailing stock price levels but both the vega and the convexity would switch to negative values if the stock prices were to fall significantly. Apparently the bank was buying these risk reversals to hedge against the negative vega and convexity exposures they had on other position in the Japanese equity derivatives.

Japanese stock prices fell sharply in 1996 and it was accompanied by a sharp rise in the implied volatility as well as a decline in the liquidity of the underlying stock positions. Falling stock prices made the warrant buyer's vega and convexity negative and the overall vega and the convexity of the book of the bank became even more negative. These factors combined to cause large trading losses.

(Referenced from from the excellent book Financial Risk Management by Steven Allen)

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