1. Alessandro / Jake Financial Engineering & Risk Management RISK & FIDUCIARY COMMITTEE Financial Engineering & Risk Management

2. October 2001Alessandro / Jake Market Asset & Liability Committee, responsible for O/N positions exceeding established guidelines. Pound Sterling Exposure is at 150 million pounds daily; currently at 700 million. Some of the Banks principal activities are foreign exchange trading and derivatives issuance. Principal trades Vs. Best-efforts basis; Credit General had less expertise in sterling than in DM and U.S. Sterling tends to be less liquid than other major currencies.

3. October 2001Alessandro / Jake Sterling / Mark Trade German Corporate Client with 1 billion pounds A/R A yard (billion pounds) 20 times the size of typical inter-bank trade. Seen as opportunity to satisfy client; enhance stature Analysis of the depth of the market to develop a strategy; Reuters screen-based dealing system, electronic broker market, telephone… Reassuring results: Expected volatility: 10% for sterling/mark & 14% dollar/mark, indications of interest from market makers, positive outlook for the sterling.

4. October 2001Alessandro / Jake Trade Execution Offer: 2.2356 DM/Sterling Current quote on Reuters: 2.2406/2.2413 … 50 pips outside the range Sterling market evaporated price and liquidity fall Less interest from market makers - herd mentality; unsubstantiated rumors of a German firm buying Marks. Laid off 250 million pounds on the U.S. bank at a 3.5 pfennig loss, only additional 50 million by the end of the day - left with a 700 million pound exposure.

5. October 2001Alessandro / Jake VAR VAR measured at the 99th percentile worst-case-outcome on a one-day basis. 3.5 pfennig movement resulted in a mark-to-market loss of DM 34.5 million. The realized loss (10.5 DM), Unrealized loss: 24.01 DM -in millions Over the last three years the worst daily move in sterling was -1.3% for a one day VAR of DM 4.4 million The worst 10 day move in Sterling was -4.1% for a 10 day VAR of DM 13.8 million. Price changes that occurred in a fraction of a day were more than the VAR measure had ever calculated.

6. October 2001Alessandro / Jake VAR Closing the position will result in further losses, keeping the O/N might expose the bank to more adverse movements VAR, based on historical losses did not fully reflect the risk Stress test incorporating realistic measures of volatility & liquidity in adverse market conditions should have been incorporated. Operational Risk was not adequately measured In the VAR valuation: Each risk measure should have been based on historical data and forward-looking estimations, Historical and other estimates of volatility, converted to potential market "events" that, if realized, would have an adverse effect on portfolio value. Examples of shocks so realized would include the stock market crash of October 1987 near-failure of Long Term Capital Management in 1998.

7. October 2001Alessandro / Jake Liquidity Statistical information reflecting market liquidity, volatility and correlation should have been incorporated in the VAR analyses. Effects of market shocks observed historically and potential market shocks deemed plausible and material on portfolio value were not assessed appropriately. Liquidity risk arises from uncertainty regarding the bid and offer prices of assets. The extreme case of liquidity risk entails the potential inability to sell assets to meet an immediate commitment. The more likely case is the deterioration in market efficiency caused by a reduction in liquidity, resulting in wider bid-offer spreads than expected for normal trading activities as in this case. Set minimum thresholds for overnight investments in each fund

8. October 2001Alessandro / Jake The risks of VaR A."VAR was never intended for use on single transactions. On the contrary, the whole appeal of the concept initially was its capacity to aggregate risk across transactions and exposures. B. Risk Management: Major Rules of Thumb (Nicholas Taleb) 1. Do not venture into markets and products you do not understand. 2. The large hit you will take next will not resemble the one that you took last. Do not listen to where the risks are (i.e., the risks shown by VaR). What will hurt you will be what you expect least. 3. Never cross a river because it it on average 4 feet deep. 4. The future does not equal the past. 5. The validity of VaR is linked to the problem of probabilistic measurement of future events, particularly those deemed infrequent (more than 2 standard deviations) and those that concern multiple securities. Internal contradiction between measuring risk (i.e. standard deviation) and using a tool with a higher standard error than that of the measure itself.

9. October 2001Alessandro / Jake Alternatives Available A. Close out of position = potentially greater loss. B. Keep position over night = exposes bank to further adverse moves. C. Hedge Risks 1. Purchase out-of-the-money sterling/mark put options a. options bid in small sizes. b. option price's implied volatility = 12% 2. Take off-setting positions in currencies correlated with the sterling/mark. a. Best correlation is dollar/mark b..3 < historical correlation <.75 c. Current correlation =.4 d. Ample liquidity in spot and option market e. option price's implied volatility = 14%

10. October 2001Alessandro / Jake Recommendation A. Cross hedge (Cross Currency Swap) 40% B. Liquidate 15% C. Hold 20% (150 MM pounds, i.e. maximum overnight position limit) D. Purchase out-of-the-money dollar/mark put options. 25%