You will write a 9-page project in which you do three case studies. The case
studies may or may not come from the Global Derivatives Debacles book. One case must be related to Forwards/Futures, one to swaps, and one to options. For this project, you will choose real-life examples and will find in practice how
companies/industries use the financial instruments discussed in class. My
preference is for a description of how the use of a derivative was relevant in
understanding a historical event (a financial crisis, a big company collapsing
because of bad risk taking or fraud, how a city was rebuilt, or a war financed,
how a historical circumstance gave rise to the creation a derivative…) Citing
your sources will be crucial for a good grade. I want to see that you looked at
financial news and respectable sources to find the information needed. The
project can be written in groups of 2, or individually.
*If, and only if, you turn in a case for “evaluation” before the exam for
that section, I will give you feedback. All three cases must be turned in as
one project at the end of the semester.
Rubric for project grade:
– Good topic and supporting articles
20%
– Detailed and clear explanation
60%
– Organized presentation and format
10%
– Completeness & length
10%
Info on project
If you choose to do as case study one of the stories in the suggested book, which I highly encourage, this suggestions are for you:
– Your case study should consist on: a brief summary of what happened plus a detailed answer to the questions at the end of the chapter. (Each story in the book ends with a list of questions that can be answered with the information in the chapter).
– Skim all the cases and read twice the one you choose for each type of derivative. First, go through the details and try to figure out what happened. Write down what you don’t understand and come to my office to ask me. Then, go back to the chapter looking for the particular answers to the questions at the end.
– Each case study should be around 3-4 pages, 1.5 or double spaced. Use times new roman or book antiqua, size 12. 1-inch margins. Any graphs can be hand made, but very tidy. The graphs are not part of the 3-4 pages measure.
– For the entire project (the 3 cases put together), do a cover page, and a content page. Put graphs/appendix at the end of each case.
– Use your own words to explain things. I have the book, I don’t need you to type whole sentences from the chapter. I want your version, in your words, of what you understand happened.
Due date: Dec 12 at noon. In my office. Printed copy. NO EMAILING.
GLOBAL DERIVATIVE DEBACLES
From Theory to Malpractice
Second Edition
2
GLOBAL DERIVATIVE DEBACLES
From Theory to Malpractice
Second Edition
Laurent L Jacque Tufts University, USA & HEC School of Management, France
3
Published by
World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE
Library of Congress Cataloging-in-Publication Data Jacque, Laurent L.
Global derivative debacles : from theory to malpractice / by Laurent L. Jacque. — Second Edition.
pages cm Includes bibliographical references and index. ISBN 978-9814663243 (alk. paper) — ISBN 978-9814663267 (alk. paper)
1. Derivative securities. 2. Finance. I. Title. HG6024.A3J335 2015 332.64’57–dc23
2015005685
British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library.
Copyright © 2015 by World Scientific Publishing Co. Pte. Ltd.
All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher.
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For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher.
In-house Editor: Sandhya Venkatesh
Typeset by Stallion Press Email: [email protected]
Printed in Singapore
5
A la mémoire de ma mère.
6
PREFACE
At a time when the global financial system is engulfed into the mother of all financial crises, it is indeed tempting and opportune to charge derivatives for creating mayhem. Are derivatives indeed “the financial weapons of mass destruction” as vilified by Warren Buffet? This book is not another treatise on financial derivatives. The purpose of this project instead is to unlock the secrets of mystifying derivatives by telling the stories of institutions, which played in the derivative market and lost big. For some of them, it was honest but flawed financial engineering which brought them havoc. For others, it was unbridled speculation perpetrated by rogue traders, whose unchecked fraud brought their house down.
Each story is unique reflecting in part the idiosyncratic circumstances of derivative use and/or misuse but, as the reader will discover, a number of key themes keep reappearing under various guises: flawed financial engineering, poor auditing, ill-designed risk management and control systems, weak governance, old-fashioned fraud … Each chapter addresses one major derivative debacle by first narrating the story before deconstructing the financial architecture behind the debacle. In the process, the reader will become acquainted with institutions encompassing universal banks, hedge funds, industrial firms, trading companies and municipalities, and their lead character or villain. Like many I find myself mesmerized by the ingenuity of these infamous derivatives and the saga of powerful institutions in the hands of which they misfired: This book is their story.
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ACKNOWLEDGEMENTS
Over the years, research projects, consulting assignments and discussions with many savvy executives and academics have helped me challenge received wisdom in the area of financial engineering, risk management and derivatives: for their insight this book is a better one. Most notably I wish to thank Daniel Ades (Kawa Fund), Y.D. Ahn (Daewoo), Blaise Allaz (HEC), Bruce Benson (Barings), Alex Bongrain (Bongrain S.A.), Charles Bravler (Oliver Wyman), James Breech (Cougar Investments), Eric Bryis (Cyberlibris), Gaylen Byker (Inter-Oil Corporation), Brian Casabianca (International Finance Corporation), Asavin Chintakananda (Stock Exchange of Thailand), Georg Ehrensperger (Garantia), Myron Glucksman (Citicorp), Anthony Gribe (J.P. Hottinguer & Cie), Charamporn Jotishkatira (Thai Airways International), Minsoo Jung (Chatham Financial), Margaret Loebl (ADM), Robert Kiernan (Advanced Portfolio Management), Oliver Kratz (Global Thematic Partners), Rodney McLauchlan (Bankers Trust), Avinash Persaud (State Street), Gabriel Hawawini (INSEAD), Jacques Olivier (HEC), Craig Owen (Campbell Soup), Guadalupe Philips (Televisa), Christoph Schmid (Bio-Oils), Jorge Ramirez (Aon Risk Solutions), John Schwarz (Citicorp), Manoj Shahi, Pat Schena (Tufts University), Sung Cheng Shih (GIC, Singapore), Roland Portait (ESSEC), Rishad Sadikot (Cambridge Associates), Charles Tapiero (NYU Polytechnic School of Engineering), Adrian Tschoegl (Wharton School), Georgi Tsekov (Standard Chartered Bank), Philip Uhlmann (Bentley College), Seck Wai Kwong (State Street), Ibrahim Warde (Tufts University) and Lawrence Weiss (Tufts University).
8
I am indebted to several individuals who selflessly read and edited several versions of the manuscript and wish to express my appreciation to David Aldama, Darius Haworon, Ellen MacDonald, Manoj Shahi, Scott Strand and Rajeev Sawant. Timely help for graphics and word-processing from Jordan Fabiansky, Martin Klupilek and Lupita Ervin is gratefully acknowledged. Last but not least I wish to thank my editor in chief — Olivier Jacque — who painstakingly reviewed the entire manuscript and asked all the hard questions.
Yet with so much help from so many I am still searching for the ultimate derivative which would hedge me from all remaining errors: but there is no escape — they are all mine.
LLJ Winchester and Paris
January 2015
9
ABOUT THE AUTHOR
Laurent L. Jacque is the Walter B. Wriston Professor of International Finance & Banking at the Fletcher School of Law and Diplomacy (Tufts University) and Director of its International Business Studies Program. He previously served as Fletcher’s Academic Dean and as such was responsible for the design and the establishment of the new Master of International Business degree and the Center for Emerging Market Enterprises. Since 1990 he has also held a secondary appointment at the HEC School of Management (France) as a Professor of Economics, Finance, and International Business. Earlier, he served on the faculty of the Wharton School (University of Pennsylvania) for eleven years where he held a joint appointment in the Management and Finance departments and the Carlson School (University of Minnesota). He also held visiting appointment at Instituto de Empresa (Spain), Pacific Management Institute (University of Hawaii), Institut Superieur de Gestion (University of Tunis), Kiel Institute of World Economics (Germany), and Chulalongkorn University (Thailand) as The Sophonpanich Research Professor in Finance and Banking.
He is the author of four books, International Corporate Finance: Value Creation with Currency Derivatives in Global Capital Markets (John Wiley & Sons, 2014), Global Derivative Debacles: From Theory to Malpractice (World Scientific, 2010) translated in French, Russian, Chinese and Korean, Management and Control of Foreign Exchange Risk (Kluwer Academic Publishers, 1996), Management of Foreign Exchange Risk: Theory and Praxis (Lexington Books, 1978) as well as more than 25 articles on International Risk Management Multinational Control Systems, Capital Markets, which have appeared in the Journal of International Business Studies, Management Science, Journal of Risk and Insurance, Journal of Operations Research Society,
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Columbia Journal of World Business, Journal of Applied Corporate Finance, Insurance Mathematics and Economics, etc. He served as an advisor and consultant to the Foreign Exchange Rate Forecasting Service of Wharton Econometrics, Forecasting Associates and as a member of Water Technologies Inc.’s board of directors. He is currently serving as a senior advisor to the Bharti Institute of Public Policy (Indian School of Business) and is a member of the Institute’s advisory board.
A recipient of five teaching awards at The Wharton and Carlson Schools, Jacque also recently won the James L. Paddock award for teaching excellence at The Fletcher School and the Europe-wide HEC-CEMS award in 2008. He is a consultant to a number of firms and the IFC (World Bank) in the area of banking, corporate finance and risk management and has taught in many Management Development Programs, including Manufacturers Hanover Trust, Merck, Sharp & Dohme, Philadelphia National Bank, General Motors, Bunge and Born (Brazil), Rhone-Poulenc (France), Siam Commercial Bank (Thailand), Daewoo (South Korea), General Electric, Dupont de Nemours, Norwest Bank, Bangkok Bank (Thailand), INSEAD, Pechiney and Petrobras (Brazil).
Laurent Jacque is a graduate of HEC (Paris) and received his MA, MBA and PhD from the Wharton School (University of Pennsylvania).
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CONTENTS
Preface
Acknowledgements
About the Author
List of Figures
List of Tables
List of Boxes
Chapter 1: Derivatives and the Wealth of Nations
What are Derivatives?
A Brief History of Derivatives
Derivatives and the Wealth of Nations
Organization of the Book
Bibliography
PART I: FORWARDS
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Chapter 2: Showa Shell Sekiyu K.K.
“Shell-Shocked By Shell Games”: The Showa Shell Debacle
Hedging Currency Risk at Oil Companies
The Mechanics of Hedging Dollar Exchange Rate Risk and Oil Price Risk
Was Showa Shell Hedging or Speculating?
Concealing Currency Losses
The Story Unfolds
Forecasting Exchange Rates: Treacherous at Best
The Moral of the Story
Chapter 3: Citibank’s Forex Losses
Currency Trading in the Tranquil Days of Bretton Woods
Gambling on Currencies with Forward Contracts
How Do Banks Keep a Lid on Their Foreign Exchange Trading Operations?
Speculating from a Commercial Bank’s Trading Desk: When Citibank is Not Quite a Hedge Fund à La Georges Soros
Hasty and Costly Conclusion
The Moral of the Story
Chapter 4: Bank Negara Malaysia
What is Central Banking All About?
Bank Negara as a Macro-Hedge Fund
How Did Bank Negara Speculate?
PART II: FUTURES
Chapter 5: Amaranth Advisors LLC
The Rise and Fall of Amaranth Advisors LLC
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Genesis of Natural Gas Derivatives
A Primer on Speculating in Natural Gas Derivatives
The Alchemy of Speculation Through Natural Gas Futures
The Story Unfolds: Amaranth Speculative Assault on Nymex
Risk Management at Amaranth
The Moral of the Story
Postscript
Chapter 6: Metallgesellschaft
The Metallgesellschaft Debacle
The “Long and Short” of Hedging in the Oil Market
Numerical Illustration of “Ebbs & Flows” Under a “Stack & Roll” Hedge
The “Message is in the Entrails”: Empirics of the Oil Market (1983–2002)
If Only MGRM had been Allowed to Roll the Dice
When a Hedge is a Gamble: Was MGRM Hedging or Speculating?
MGRM as a Market Maker
The Moral of the Story
Bibliography
Chapter 7: Sumitomo
Was Sumitomo Manipulating Copper Prices?
Alarm Bells
Debacle
Postscript
PART III: OPTIONS
14
Chapter 8: Allied Lyons
A New Mission for Allied Lyons Treasury Department
A Primer on Currency Options: Was Allied Lyons Hedging or Speculating?
Selling Volatility: Allied-Lyons “Deadly Game”
Alarm Bells are Ignored as the Story Unfolds
The Moral of the Story
Appendix: Pricing Currency Options
Chapter 9: Allied Irish Banks
Rusnak and Currency Trading at Allfirst
Gambling on Currencies with Forward Contracts
Arbitraging the Forward and Option Market: The International Put-Call Parity Theorem
The Art of Concealment
When Alarm Bells are Ignored
The Moral of the Story
Epilogue
Bibliography
Chapter 10: Barings
The Rise and Fall of the House of Barings
Rogue Trader
Arbitrage
From Harmless Arbitrage to Lethal Speculation
A Primer on How to Speculate with Options
Financing Margin Calls by Selling Volatility
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Warning Bells
The Art of Concealment
The Moral of the Story: Leeson’s Seven Lessons
Epilogue
Bibliography
Chapter 11: Société Générale
The Making of a Rogue Trader
From Arbitrage to Directional Trades
Hasty Conclusion
When Alarm Bells are Ignored
The Art of Concealment
The Moral of the Story
Postscript
Bibliography
PART IV: SWAPS
Chapter 12: Procter & Gamble
How to Reduce Financing Costs with Levered Interest Rate Swaps
Embedded Options and Hidden Risks
Landmark Lawsuit
The Moral of the Story
Bibliography
Chapter 13: Gibson Greeting Cards
Chapter 14: Orange County
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Municipal Finance in Orange County
A Primer on Fixed Income Securities
Anatomy of Orange County Asset Portfolio
OCIP as a Hedge Fund
Double Jeopardy: How Orange County Collapsed
Was Filing for Bankruptcy Warranted?
The Moral of the Story
Epilogue
Bibliography
Chapter 15: Long-Term Capital Management
What are Hedge Funds?
The Rise of Long-Term Capital Management
The Alchemy of Finance
Relative Value or Convergence Trades
The Central Bank of Volatility
Straying Away from the Master Plan
The Fall of LTCM
The Rescue of LTCM
The Moral of the Story
Epilogue
Bibliography
Chapter 16: AIG
Securitization and Credit Default Swaps
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What are Credit Default Swaps (CDSs)?
A Stealth Hedge Fund at AIG
The Moral of the Story
Postscript
Chapter 17: JP Morgan Chase London Whale
The JP Morgan Chase Fortress
A Primer on Credit Default Swaps and Their Extended Family
The London Whale: The Story Unfolds
Hedge Funds Harpoon the London Whale
A Stealth Hedge Fund?
The Art of Concealment
The Moral of the Story
Postscript
Chapter 18: From Theory to Malpractice: Lessons Learned
Some First Principles
Policy Recommendations for Non-Financial Firms
Policy Recommendations for Financial Institutions
Policy Recommendations for Investors
Policy Recommendations for Regulators
Index
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LIST OF FIGURES
Chapter 1 Figure 1 Percent change in yen/USD exchange rate
Chapter 2 Figure 1 Monthly spot oil prices (1989–1993) Figure 2 Yen price of the dollar (1989–1994) Figure 3 Showa Shell’s economic exposure Figure 4 Forward rates as unbiased predictors of future spot exchange rates.
Monthly Data 30 day Forward vs. Spot Yen per Dollar
Chapter 3 Figure 1 $/£ exchange rate fluctuations (1964–1965) Figure 2 $/£ exchange rate vs. US and UK interest rates (1964–1965)
Chapter 5 Figure 1 Excessive Speculation in the Natural Gas Market Figure 2 Back-testing calendar spread speculation Figure 3 Natural gas futures prices Figure 4 U.S. natural gas, monthly production Figure 5 Natural gas in storage
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Figure 6 Amaranth’s outstanding futures positions Figure 7 Amaranth’s gas contracts for November Figure 8 Amaranth’s open interest in natural gas contracts Figure 9 January/November futures price spreads 2002–2006 Figure 10 Amaranth’s outstanding futures positions
Chapter 6 Figure 1 Unhedged “short” oil positions years 1–10 Figure 2 Hedged oil positions years 1–10 Figure 3 Stack of futures in year 0 to hedge short position years 1–10 Figure 4 Stack and roll Figure 5 (A) Example of a market in backwardation
(B) Example of a market in contango Figure 6 (A) Average monthly crude oil backwardation
(B) Average monthly heating oil backwardation (C) Average monthly gasoline backwardation
Figure 7 Cash flows from hedged oil deliveries Figure 8 Cash flows from “Stacking and Rolling” futures hedge
Chapter 8 Figure 1 Buying and writing put options Figure 2 Hedging with put options Figure 3 Buying and writing call options Figure 4 Writing a covered call option Figure 5 Value of a sterling call option prior of maturity Figure 6 Daily exchange rates (in US $/£) Figure 7 Daily volatility for US $/£ Figure 8 Writing a straddle Figure 9 Writing a strangle
Chapter 9 Figure 1 Payoff from speculating through a forward contract
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Figure 2 Yen/dollar exchange rate 1996–2001 Figure 3 (A) Creating a synthetic forward contact
(B) Arbitrage profit (C) International put-call parity
Figure 4 Yen call option + yen forward = yen put
Chapter 10 Figure 1 Profit loss profile of going long on Nikkei 225 index futures Figure 2 Cumulative losses on Nikkei 225 futures Figure 3 Cumulative losses on Japanese government bond futures Figure 4 Payoff of put option on Nikkei 225 index futures Figure 5 Payoff of call option on Nikkei 225 index futures Figure 6 Value of a call option premium Figure 7 Payoff from writing a straddle Figure 8 Payoff from writing a strangle Figure 9 Combining a straddle and a long position Figure 10 Leeson’s cumulative losses due to selling/writing options
Chapter 11 Figure 1 Buying a covered call option = buying a naked put Figure 2 Date of Kerviel’s manager departure (23/01/07) Figure 3 Kerviel’s “actual” trading Figure 4 Estimated amount of fictitious gains/losses created by Kerviel Figure 5 Total cumulated cash paid by SoGen to FIMAT
Chapter 12 Figure 1 The Proctor & Gamble — Bankers Trust interest rate swap Figure 2 Writing put options on US treasuries
Chapter 14 Figure 1 Path of interest rates Figure 2 Distribution of possible gains and losses on OCIP
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Chapter 15 Figure 1 LTCM’s performance Figure 2 Payoff from writing a straddle Figure 3 Payoff from writing a strangle
Chapter 16 Figure 1 Building Blocks of securitization
Chapter 17 Figure 1 Credit Default Swaps (CDSs) Figure 2 Credit spreads Figure 3 Value-at-Risk for the Chief Investment Office (CIO Global 10Q
V@R) Figure 4 Grout Spreadsheet showing variance between reported losses and
fair market losses
22
LIST OF TABLES
Chapter 1 Table 1 Contents of the Book
Chapter 3 Table 1 Matrix of currency positions by maturity
Chapter 6 Table 1 Cash flow gain/loss from hedging through “stacking and rolling” oil
futures Table 2 Oil price decline overshoots backwardation discount Table 3 Oil price decline undershoots contango premium
Chapter 10 Table 1 Funding provided to Leeson’s BFS Table 2 Fact versus fantasy: Profitablity of Leeson’s trading activities Table 3 Fantasy versus fact: Leeson’s positions at end of February 1995
Chapter 12 Table 1 Simulations on the Procter & Gamble’s leveraged swap Table 2 Multiple scenario analysis
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Chapter 13 Table 1 LIBOR
Chapter 14 Table 1 OCIP assets portfolio Table 2 Balance sheet of Orange County Investment Pool
Chapter 15 Table 1 LTCM partners Table 2 LTCM losses according to the nature of its trades
Chapter 17 Table 1 SCP portfolio performance under bullish and bearish scenarios Table 2 Compensation of SCP key employees in millions of dollars
Chapter 18 Table 1 Vulnerability to derivative debacles for non-financial firms Table 2 Vulnerability to derivative malpractice for financial institutions
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LIST OF BOXES
Chapter 2 Box A The Oil Market Box B What Are Forward Contracts? Box C How to Hedge a $300 Million Monthly Oil Bill? Box D Valuing Forward Exchange Rates and the Interest Rate Parity
Theory
Chapter 3 Box A The Bretton Woods System of Fixed Exchange Rates Box B What Are Forward Contracts? Box C Valuing Forward Exchange Rates and the Interest Rate Parity
Theory
Chapter 4 Box A Central Banks’ Intervention in Currency Markets Box B The European Monetary System (EMS) and the European Exchange
Rate Mechanism (ERM)
Chapter 5 Box A What are Hedge Funds?
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Box B The US Natural Gas Industry Box C Gas Futures Box D Options on Gas Futures Box E What are Weather Derivatives? Box F What is Open Interest? Box G Value-at-Risk (V@R)
Chapter 6 Box A The Oil Market Box B What are Forward Contracts? Box C Oil Futures Box D What is Different Between Forward and Futures Contracts Box E Optimal Hedge Ratio
Chapter 7 Box A The London Metal Exchange (LME) Box B Silver Price Manipulations and the Demise of the Hunt Brothers
Chapter 8 Box A Currency Option Contracts Box B Valuation of Currency Options Box C Volatility and the Value of Options
Chapter 9 Box A Proprietary Trading Box B What Are Forward Contracts? Box C What Are Currency Options Box D Basel II and Capital Charges for Proprietary Trading
Chapter 10 Box A Front and Back Offices Box B What is a Nikkei 225 Index Futures?
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Box C Interest Rates, Bond Prices and Japanese Government Bond Futures Box D Valuation of Stock Index Futures Options Box E Volatility and the Value of Options
Chapter 11 Box A Front, Middle, and Back Offices Box B Turbo Warrant Box C What is a Stock Index Futures? Box D What is a Short Sale?
Chapter 12 Box A What are Interest Rate Swaps? Box B Bond Valuation Box C Put Options on Interest Rates Box D Interest Rate Swap on Deutsche Mark (DM)
Chapter 14 Box A Bond Valuation Box B What Are Hedge Funds? Box C Repurchase Agreements (Repos) and Reverse Repurchase
Agreements Box D Leverage as a Double-Edged Sword Box E Collateral Call Box F Value-at-Risk (V@R)
Chapter 15 Box A Hedge Funds’ Unorthodox Investment Strategies Box B Interest Rates and Bond Prices Box C What is a Short Sale? Box D What are Interest Rate Swaps? Box E The Extended Family of “Converging Spreads” Box F Volatility and the Value of Options
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Chapter 16 Box A What is Securitization? Box B How Do Credit Default Swaps Differ from Bond Insurance?
Chapter 17 Box A Capital Adequacy Ratios (CARs) Box B CDS Spreads and Bond Yields Box C Trading Credit Default Swaps Box D Risk-weighted Assets (RWAs) Box E Value-at-Risk (V@R) Box F What are hedge funds?
Chapter 18 Box A Operational Risk Box B The Volcker Rule
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1 DERIVATIVES AND THE WEALTH OF
NATIONS
Derivatives are financial weapons of mass destruction. Warren Buffet
At a time when the world economy is engulfed into the mother of all financial crises, it is indeed tempting and opportune to find derivatives guilty as charged for creating financial chaos. This book is not an indictment of financial derivatives to be feared as “financial weapons of mass destruction” nor is it a call for multilateral disarmament or signing a nonproliferation treaty! Derivatives may be feared but they cannot be avoided nor ignored (abstinence is not an option) as they permeate many of the key goods and services which are at the core of modern life: for example, the price of energy is largely influenced by oil and natural gas derivatives and the cost of securitized consumer finance (variable rate home mortgages and automobile loans) embodies interest rate derivatives and credit default swaps.
Instead this book recounts the financial debacles which — triggered by the misuse of derivatives — devastated both financial and nonfinancial firms. By presenting a factual analysis of how the malpractice of derivatives played havoc with derivative end-user and dealer institutions, a case is made for vigilance not
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only to market and counterparty risk, but also operational risk in their use for risk management and proprietary trading. Clear and recurring lessons across the different stories should be of immediate interest to financial managers, bankers, traders, auditors, and regulators who are directly or indirectly exposed to financial derivatives. The second purpose of this book is more modest: by telling real-life “horror” stories it purports to debunk the mystifying pseudocomplexity of derivatives and to take the uninitiated reader on a “grand tour” of financial engineering and derivatives. Indeed the reader is introduced step by step to real-life companies and the vicissitudes that they experienced in misusing the arcane derivatives.
WHAT ARE DERIVATIVES?
Derivatives are financial contracts, whose value is “derived” from the future price of an underlying asset such as currencies, commodities, interest rates, and stock price indices. Even though each chapter will introduce one specific derivative in much detail, it is helpful at this early stage to provide definitions for the four major families of derivatives, whose architecture is identical across different classes of underlying assets:
Forwards are legally-binding contracts calling for the future delivery of an asset in an amount, at a price and at a date agreed upon today. For example, a 90-day forward purchase of 25 million pound sterling (£) at the forward rate of $1.47 = £1 signed on April 13, 2015 happens in two steps: today, April 13, 2015 a contract is signed spelling out the nature of the transaction (forward purchase of the pound sterling), the amount (£25 million), the price ($1.47), the time of delivery (90 days hence or July 17, 2015) but nothing happens physically beyond the exchange of legal promises. Ninety days later, the contract is executed by delivering £25 × 1.47 = $36.75 million and taking delivery of £25 million. The contract is carried out at the forward rate regardless of the spot price (that is the price prevailing on delivery day) of the pound sterling. Forwards are tailor-made contracts also known as over- the-counter and — as such — expose the signatories to counterparty risk — that is the risk that the other party may default on its delivery obligations. Forwards are available on commodities such as copper or oil and other assets. Forwards will be the “financial weapon of mass destruction” in the
30
first three chapters involving respectively a major Japanese oil company Showa Shell, Citibank, and Bank Negara — the Central Bank of Malaysia. Futures are close cousins of forward contracts with some material differences. Futures are standardized contracts, whose amount and delivery date are set by an organized exchange: for example, sterling futures can only be delivered in March, June, September, and December (third Wednesday of calendar month) and are available in multiples of £62,500). The lack of flexibility in designing a tailor-made contract (as in the case of forwards) is compensated by the liquidity of the contract, which can be closed at any time before expiry. Because futures are entered with well-capitalized exchanges such as the Chicago Board of Trade or the New York Mercantile Exchange, there is no counterparty risk to be concerned with as the exchange will require any contract holder to post a margin — a form of collateral — which ensures that the contract holder is able to fulfill the terms of the contract at all times regardless of the spot price. Futures will be the “financial weapon of mass destruction” in Chapters 5, 6, and 7 featuring respectively the hedge fund Amaranth Advisors LLC, the German metal- processing and engineering firm Metallgesellschaft and the Japanese trading company Sumitomo. Options are securities which give you the right to buy (call option) or sell (put option) an asset (currency, commodity, stocks, bonds) for an extended period (American option) or at a particular future point in time (European option) at an agreed price today (strike price) for an upfront cash-flow cost (premium). In one of the largest options ever contracted, U.K. company Enterprise Oil Ltd. paid more than $26 million for a 90-day currency option to protect against exchange rate fluctuations on $1.03 billion of the $1.45 billion that it had agreed to pay for the oil exploration and production assets of U.S.-based transportation company Texas Eastern Inc. The option — a dollar call option — gave Enterprise the right to buy dollars at a dollar/sterling rate of $1.70. The dollar/sterling exchange rate was $1.73 when Enterprise Oil bought the option on March 1: “We are bearish on sterling,” says group treasurer Justin Welby. “And we did a very careful calculation between the price of the option premium (which is cheaper the further out-of-the-money) and how much we could afford the dollar to strengthen. We decided that this was the best mix between the amount of protection we could forgo and the amount of upfront cash we were prepared to pay out for the option.1” Ninety days later, the pound stood at $1.7505, which made the call option just about redundant at the modest cost of $26
31
million for Enterprise Oil Ltd. Options are available not only on currencies, but also on stock price indices, interest rates, and commodities. They are the “financial weapon of mass destruction” in Chapters 8, 9, 10, and 11 featuring respectively Allied Lyons, Barings Bank, Allied Irish Banks, and Société Générale. Swaps are contracts between two parties agreeing to exchange (swap) cash- flows over a determined period. The most common swaps are interest rate swaps — where one party pays a fixed interest rate based on a notional amount and the counter-party pays a floating rate keyed to the same notional amount. Cross-currency and commodity swaps are also common. Mexicana de Cobre — a Mexican copper-mining company — decided to hedge against volatile copper prices on the London Metal Exchange2 to secure medium- term financing at significantly more favorable terms than it was currently paying. It entered into a copper price swap with Metallgesellschaft (one of the leading metal-processing firms) whereby for a period of 3 years it committed to deliver monthly 4,000 metric tons of copper at a guaranteed price of $2,000 per metric ton regardless of the spot price on the world market. In effect the swap was tantamount to a portfolio of 36 forward contracts with maturities ranging from 1 to 36 months at a forward rate of $2,000 per metric ton. Most swaps are over-the-counter rather than exchange-traded. They are the “financial weapons of mass destruction” in Chapters 12, 13, 14, 15, 16 and 17 featuring respectively Procter & Gamble, Gibson Greeting Cards, Orange County, Long-Term Capital Management and last but not least AIG and JP Morgan Chase.
A BRIEF HISTORY OF DERIVATIVES
From immemorial times, traders have been faced with three problems: how to finance the physical transportation of merchandise from point A to point B — perhaps several hundreds or thousands of miles apart and weeks or months away — how to insure the cargo (risk of being lost at sea or to pirates) and last, how to protect against price fluctuations in the value of the cargo across space (from point A to point B) and over time (between shipping and delivery time). In many ways, the history of derivatives contracts parallels the increasingly innovative remedies that traders devised in coping with their predicament.
Ancient Times. Trade carried over great distance is probably as old as
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mankind and has long been a source of economic power for the nations which embraced it. Indeed international trade seems to have been at the vanguard of human progress and civilization: Phoenicians, Greeks, and Romans were all great traders, whose activities were facilitated by marketplaces and money changers which set fixed places and fixed times for exchanging goods. Some historians even claim that some form of contracting with future delivery appeared as early as several centuries BC. At about the same time in Babylonia — the cradle of civilization — commerce was primarily effected by means of caravans. Traders bought goods to be delivered in some distant location and sought financing. A risk-sharing agreement was designed whereby merchants- financiers provided a loan to traders, whose repayment was contingent upon safe delivery of the goods. The trader borrowed at a higher cost than ordinary loans would cost to account for the purchase of an “option to default” on the loan contingent upon loss of cargo. As lenders were offering similar options to many traders and thereby pooling their risks they were able to keep its cost affordable.3
Middle Ages. Other forms of early derivatives contracts can be traced to medieval European commerce. After the long decline in commerce following the demise of the Roman Empire, Medieval Europe experienced an economic revival in the twelfth century around two major trading hubs: in Northern Italy, the city-states of Venice and Genoa controlled the trade of silk, spices, and rare metals with the Orient; in Northern Europe, the Flanders (Holland and Belgium) had long been known for their fine cloth, lumber, salt fish, and metalware. It was only natural that trade would flourish between these two complementary economic regions and somehow, as early as the 1100s, Reims and Troyes in Champagne (Eastern France) held trade fairs, which facilitated their mercantile activity: there, traders would find money changers, storage facilities, and most importantly protection provided by the Counts of Champagne. Soon rules of commercial engagement started to emerge as disputes between traders hailing from as far-away as Scandinavia or Russia had to be settled: a code of commercial law — known as “law merchant” — enforceable by the “courts of the fair” was progressively developed. Although most transactions were completed on a spot basis “an innovation of the medieval fairs was the use of a document called the “lettre de faire” as a forward contract which specified the delivery of goods at a later date.”4
In 1298, a Genoese merchant by the name of Benedetto Zaccharia was selling 30 tons of alum5 for delivery from Aigues Mortes (Provence) to Bruges
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(Flanders).6 Maritime voyage around Spain and the Atlantic coast of France was then hazardous and fraught with dangers: the cargo could be lost at sea or to pirates. Zaccharia found two compatriot financiers Enrico Zuppa and Baliano Grilli, who would assume the risk. Here is how it worked: Zaccharia sold “spot”7 the alum to Zuppa and Grilli and entered into a forward repurchase contract contingent upon physical delivery. The repurchase price was significantly higher than the spot price in Aigues Mortes. It reflected the cost of physical carry from Aigues Mortes to Bruges (several months at sea), insurance against loss of cargo and the option to default granted to Zaccharia in the case of nondelivery. The merchant Zaccharia had secured financing and insurance in the form of a forward contingent contract.
Renaissance. If medieval fairs had gone a long way in establishing the standards for specifying the grading and inspection process of commodities being traded as well as date and location for delivery of goods, it fell short of the modern concept of futures traded on centralized exchanges. The first organized futures exchange was the Dojima rice market in Osaka (Japan), which flourished from the early 1700s to World War II. It grew out of the need of feudal landlords whose income was primarily based on unsteady rice crops to cope with a growing money economy. By shipping surplus rice to Osaka and Edo, landlords were able to raise cash by selling warehouse receipts of their rice inventory in exchange for other goods on sale in other cities. Merchants who purchased these warehouse receipts soon found themselves lending to cash- short landlords against future rice crops. In 1730, an edict by Yoshimune — also known as the “rice Shogun” — established futures trading in rice at the Dojima market apparently in an effort to stem the secular decline in rice prices. It certainly allowed rice farmers to hedge against price fluctuations between harvests. Interestingly, all the hallmarks of modern standardized futures contract were found in the Dojima rice futures market8: each contract was set at 100 koku9 and contract durations were set according to trimester trading calendars consisting of a spring semester (January 8–April 28), summer term (May 7– October 9), and a winter term (October 17–December 24). All trades were entered in the “book” transaction system, where the names of the contracting parties, amount of rice exchanged, futures price, and terms of delivery were recorded. Transactions were cash-settled (delivery of physical rice was not necessary) at the close of the trading term. Money changers soon functioned as clearinghouses de facto eliminating the counterparty risk by forcing margin requirements on individual rice traders, which were marked-to-market every 10
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