Question

(9) What was the money making strategy of the Synthetic Derivative Portfolio (London Whale)? And how does it go wrong? (10 points)

Answer 1

9) A synthetic derivative portfolio strategy may allow an investor to implement a position at a lower cost than a direct investment in the capital market. For example - foreign investors subject to dividend withholding taxes may find a synthetic long stock position using options an attractive alternative to the cash investment. Synthetic calls can be created by borrowing, investing in stock and buying put options. Similarly,a synthetic protective put strategy can be established by buying call options and discount bonds.In JP Morgan and London Whale case, the synthetic credit positions were based on standarised credit default swap (CDS) indices. The positions were the sale and purchase of protection against credit events of the corporate issuers tied to the basket of CDS included in the indices.

The Risk Management specially for the credit derivatives portfolio of the CIO unit does not appear to have been a priority until after the size of the synthetic credit portfolio had already become unwieldly in January 2012. The task force assigned by JP Morgan Chase Bank to investigate the CIO losses reported the risk of the trading strategies were neither adequately analyzed nor questioned prior to the implementation. Further ,the firm's own review showed that the synthetic credit portfolio was not protected against various market scenarios.