UBS’ Kweku Adoboli has now been charged with one count of fraud by abuse of position and two counts of false accounting. Supposedly, he made a rogue trade that cost the Swiss bank $2 billion.
Details have yet to emerge about the nature of the trade. But we wondered if it was possible for one trader to lose $2 billion while being within boundaries of prudent risk management guidelines.
The answer seems to be yes.
To better understand why, you must understand value-at-risk, or VaR.
VaR is one of the most common ways to measure how much money a bank has at risk. In a nutshell, VaR is the maximum amount of money one could lose over a certain period of time given a certain level of confidence.
For example, if you had a one day VaR of $100 at a 95% level of confidence, then there is a 95% chance you won’t lose more than $100 in one day.
However, this doesn’t mean that the worst-case-scenario loss in a given day is capped at $100. In fact, thanks to the existence of derivatives and the ability to short, the maximum loss for a trading department can be unknown. Such weaknesses have drawn criticism from the likes of hedge fund manager David Einhorn and The Black Swan author Nassim Taleb, who calls VaR a “fraud.”
So, now we have framework in which to think about UBS’ $2 billion loss.
DealBreaker’s Matt Levine did some digging and found that the UBS investment bank’s maximum one day VaR at a 95% confidence level was 98 million Swiss francs, or around $113 million, at the end of the second quarter.
After crunching the numbers, Levine concluded that losing $2 billion would’ve been a 29 standard deviation event, effectively a statistical impossibility.
So, here’s one way the whole UBS’ trade might’ve gone down: Kweku Adoboli comes into work one day and goes to his manager with a trade idea. He presents a couple of negative scenarios including one absolutely insane scenario just for kicks. “Boss, there’s a chance I might lose $2 billion dollars on this trade. But that would be a 29 standard deviation event, which means I’m more likely to get struck by lightning while riding on the back of a flying pig!” Both laugh and Adoboli gets the go-ahead.
We still don’t know the nature of Adoboli’s alleged rogue trade. Many are speculating he was long the Swiss franc, which made a 20 standard deviation move after the Swiss National Bank announced a cap to the CHF/EUR exchange rate.
We have been waiting to hear who got burned on that move. Perhaps it was UBS.
That being said, there are stories about how some trades were in place since 2008, and how he had to tell his bosses about the trade, so obviously the above is probably an extreme simplication.
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