NatWest Markets (NWM) was the investment banking arm of National Westminster Bank, one of the largest banks in the United Kingdom. On 28 February 1997, NWM revealed that a substantial loss had been uncovered in its trading books. During the 1990s, NatWest was engaged in trading interest rate options and swaptions on several underlying currencies. The trading required setting appropriate prices of the options by the traders at NatWest. A key parameter in setting the price of an interest rate option is the implied volatility of the underlying assetthat is, the interest rate on a currency. In contrast to other optional parameters that affect the option prices, such as duration to maturity and exercise price, implied volatility is not directly observable and must be estimated. Many option pricing models imply that the implied volatility should be the same for all options on the same underlying, irrespective of their exercise price or maturity. In practice, however, implied volatility is often observed to have a curvilinear relationship with the options moneyness (i.e., whether the option is out of the money, at the money, or in the money), a relationship sometimes called the volatility smile. Implied volatility tended to be higher for out-of-the-money options than for at-the-money options on the same underlying.

NWM prices on certain contracts tended to consistently undercut market prices as if the out-of-the-money options were being quoted at implied volatilities that were too low. When trading losses mounted in an interest rate option contract, a trader undertook a series of off-market-price transactions between the options portfolio and a swaptions portfolio to transfer the losses to a type of contract where losses were easier to conceal. A subsequent investigation revealed that the back office did not independently value the trading positions in question and the lapses in trade reconciliation had occurred.

What type or types of risk were inadequately managed in the above cases?