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.

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