Suppose a Large-cap Mutual Fund is benchmarked to a particular Index. Index and the same Mutual Fund realised the following returns over 5 years –…

To assess the Fund's performance vis-à-vis the benchmark we shall compute the Tracking Error as follows: Year Index Return (%) Mutual Fund Return (%) Diff. (%) (Diff. – Mean Diff.) (Diff. – Mean Diff.) 2 1 8.00 7.00 -1.00 -1.10 1.21 2 3.00 2.00 -1.00 -1.10 1.21 3 9.00 8.00 -1.00 -1.10 1.21 4 6.00 9.00 +3.00 2.90 8.41 5 5.00 5.50 +0.50 0.40 0.16 Total +0.50 12.20 d = Average differential return = 0.50 / 5 = 0.10 The Tracking Error is calculated as follows: TE = √[Σ(d - d̄) 2 / (n-1)] TE = √(12.20 / 4) = 1.75% Since the Tracking Error is only 1.75%, it can be inferred that the Fund has closely tracked the Benchmark Index. OR / Alternative Solution: Following are some of the important lessons can be learnt from the above-mentioned case studies of Derivative Mishaps. (i) Don't buy any derivative product that you don't understand: This is an important lesson for non-financial corporation not to undertake a trade or derivative product that they do not understand. As apparent in case of Orange County, treasurer Robert Citron speculated on derivative instruments even though he has no financial background. Similar things happened in BT's case where both P&G and Gibson Greetings were misguided. The best way to avoid such loss is to value the instrument in house because outside persons can misguide the corporation about the potential dangers. (ii) Due diligence before making Treasury Department as a Profit Centre: Though the main objective of establishing a Treasury Department is to reduce financing costs and manage risk optimally. But it has been seen that though initially Treasury Department made limited profits from treasury activities later started taking more risks in anticipation of higher profit. In case study of Orange County the treasurer Citron with initial profit from yield curve play strategy leveraged its position and led to bankruptcy. The best way to avoid this situation is to avoid linking the treasurer's salary with the profit he made for the organization. (iii) Specify the Risk Limits: Proper monitoring is prerequisite for the trader to ensure that he/she should switch from arbitrageur to speculator. As happened in Baring Bank's case where position taken by rouge trade Nick Leeson remained unmonitored and unquestionable by the management. The best way to avoid the situation of overtrading is to limit the sizes positions that can be taken by a trader, and it should be accurately reported from risk perspective. (iv) Separation of Front, Middle and Back Offices: The three offices though are interlinked but they discharge separate functions. Accordingly, there should be a firewall in the functioning of these offices i.e. person of one office should not have the access to the functioning of other office. Barings bank's case is a classic example where Nick Leeson carried out manipulations in back office (which was under his control also) and hid the losses in error account. To ensure that these three offices work independently it is essential that role and functions of each office should be clearly defined and followed. (v) Carry out Stress Test, Scenario Analysis etc.: As happened in the case of BT where Gibson Greetings where it was believed that the interest rates shall remain lower and to some extent ignored the possibility of increasing of interest rates by 1%. But it happened and ultimately Gibson Greetings faced a huge loss. To counter this type of unpredictable situation it is necessary that VAR analysis should always be followed by Scenario Analysis because as tendency a human being normally can anticipate two to three scenarios. It will be better to refer the data of at least 10 to 20 years to anticipate a Black Swan event. Further even Simulation Test can be applied to analyze the results in various possible situations. Note: Explain any two lessons out of two above-mentioned lessons.