A:

In 1993, Allfirst Bank hired a currency trader to shift the bank's forex (FX) operations from a merely hedging endeavor to one that would yield profits and boost the bank's bottom line. To this end, Allfirst brought on John Rusnak, who had a decent track record in foreign currency trading at Fidelity and Chemical Bank. Specifically, Rusnak seemed adept at matching options with forward contracts to hedge against risk.

John Rusnak was bullish on the yen. He believed the yen had taken all the damage it could following the bursting of the Japanese bubble. Further, Rusnak believed the yen would appreciate consistently against the dollar. Under these conditions, a trader normally would buy forward contracts to get yen for cheaper than market value, while hedging the position with a combination of put and call options. In practice, Rusnak was so bullish on the yen that he neglected to hedge his forward contracts. His luck held, however, until a series of policy changes in Asia culminated in crisis on the Asian market and prompted a long slide in the value of the yen and other Asian currencies.

With his unhedged positions facing losses, Rusnak panicked. He entered false options into the system that made it look like his positions were hedged. While the options kept the bank from discovering the losses, he set about doubling his bets on the rise of the yen. Rusnak convinced his superiors that a prime brokerage account would allow him to wring higher profits from the growing currency operations. Prime brokerage accounts generally are given to hedge funds and high profile traders with a lot of capital to play with. However, Rusnak was granted the account despite the fact that, unbeknownst to his superiors, he already was working in the red.

With his new account, Rusnak increased the size of his trades and kept his losses hidden by using options and a higher level forex contract called a historical rate rollover. This allowed him to hold off realizing his losses, while still betting more on the yen. It also meant that the total value of the forex operations at Allfirst was increasing. Even though the losses were barely detectable, the increasing amount of capital being tied up in the currency market was obvious. When the bank demanded that Rusnak release some of the capital to ease its balance sheet of the heavy skew towards the forex market, the house of cards came tumbling down.

Rusnak's positions revealed a staggering loss of $691 million. Allfirst and its parent bank Allied Irish hoped that Rusnak was party to a grander conspiracy to fleece the bank for profit, but Rusnak had not earned anything above his regular salary and bonuses. Rusnak cooperated with the FBI and revealed how he had been able to maneuver around the bank's loose restrictions. Rusnak's transparency with the FBI hurt Allfirst because it had no one to blame but its own permissive policies. Of course, shareholders took the bank to task over the matter. Allied Irish's stock fell sharply, but it proved more robust than Barings had been after the Nick Leeson scandal. John Rusnak was sentenced to seven and a half years in prison and fined $1 million.

(For more on this topic, read Trading's 6 Biggest Losers.)

This question was answered by Andrew Beattie.

RELATED FAQS
  1. What is hedging as it relates to forex trading?

    When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted ... Read Answer >>
  2. How do you lose money in the Forex market?

    All trades made in the forex market are made in pairs. In other words, one currency is always quoted against another currency, ... Read Answer >>
  3. What is the difference between diversification and hedging?

    Learn what diversification and a hedge are, how investors can diversify and hedge their investments, and the main difference ... Read Answer >>
  4. Can I trade a currency when its main market is closed?

    In the forex market, currencies from all over the world can be traded at all times of the day. The forex market is very liquid, ... Read Answer >>
  5. Is it possible to trade forex options?

    Yes. Options are available for trading in almost every type of investment that trades in a market. Most investors are familiar ... Read Answer >>
  6. What am I buying and selling in the forex market?

    The forex market is the largest market in the world. According to the Triennial Central Bank Survey conducted by the Bank ... Read Answer >>
Related Articles
  1. Trading

    Trading's 6 Biggest Losers

    These "rogue traders" are famous for their billion-dollar mistakes.
  2. Trading

    The Forex Market: Who Trades Currency And Why

    The forex market has a lot of unique attributes that may come as a surprise for new traders.
  3. Trading

    Forex Trading: A Beginner's Guide

    Learn about the forex market and some beginner trading strategies to get started.
  4. Trading

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
  5. Investing

    From Mrs. Watanabe To Abenomics: The Yen's Wild Ride

    Relatively recent upstarts like the euro and the yuan may hog the currency headlines these days, but for sheer drama and gut-wrenching volatility, no currency can match the venerable Japanese ...
  6. Trading

    The Most Famous Forex Traders Of All Time

    The five most famous forex traders share common virtues such as strong self-confidence.
  7. Trading

    Can Forex Trading Make You Rich?

    Forex trading may be profitable for hedge funds or unusually skilled currency traders, but for average retail traders, forex trading can lead to huge losses.
  8. Trading

    Trading Forex Options: Process And Strategy

    What are the processes to trade forex options on most liquid currency pairs, and what are some strategies for success?
  9. Trading

    The Money Market Hedge: How It Works

    Investopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
  10. Investing

    4 Reasons Currency Hedging is Important

    Learn how currency hedging can help reduce exchange rate risk for a portfolio of foreign stocks. Consider the cost of hedging and its potential benefits.
RELATED TERMS
  1. Forex Hedge

    A transaction implemented by a forex trader to protect an existing ...
  2. Foreign Exchange Market

    The market in which participants are able to buy, sell, exchange ...
  3. Forex Option & Currency Trading Options

    A security that allows currency traders to realize gains without ...
  4. Forex Market

    The market in which participants are able to buy, sell, exchange ...
  5. Nick Leeson

    A former manager with England's Barings Bank, Leeson became a ...
  6. Hedge

    Making an investment to reduce the risk of adverse price movements ...
Hot Definitions
  1. IRS Publication 970

    A document published by the Internal Revenue Service (IRS) that provides information on tax benefits available to students ...
  2. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  3. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  4. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  5. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  6. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
Trading Center