Description
This is a presentation describes various disasters which happened because of derivatives.
Derivatives Disasters
Presented By: Group I MBA (II) Finance 16th August,2008
It can‘t get bigger…
Société Générale
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Year of Scam – 2008
Impact ( Total Loss) -$7 billion, the biggest loss ever recorded in the financial industry by a single trader Derivative Instrument - European Index Futures
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Key Person - Jérôme Kerviel
About Société Générale
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One of the oldest banks in France established in 1864 Revenue - € 21.923 billion (2007) Net Income - € 1.604 billion (2007) Employee - 130,100 (2007) In 77 countries worldwide
Divisions: ? Retail Banking & Specialized Financial Services ? Corporate and Investment Banking ? Global Investment
Chronology of Events
Friday January 18th ? Abnormal counterparty risk on a broker is detected several days earlier. The explanations provided by the trader result in additional controls. ? In the afternoon of January 18th, it appears that the counterparty for the recorded operations is in fact a large bank, but the confirmation e-mail raises suspicions. Investigation for the same started Saturday January 19th ? The large bank in question does not recognise the operations ? The trader finally acknowledges committing unauthorised acts creating fictitious operations
Sunday January 20th ? All of the positions are identified and the extent of the total exposure is known Monday January 21st ? The unwinding of the fraudulent position begins in particularly unfavourable market conditions Wednesday January 23rd ? The unwinding of the fraudulent position is completed Thursday January 24th ? Bank announced that a single futures trader at the bank had fraudulently lost the bank 4.9 billion € (an equivalent of 7.2 billion dollars), the largest such loss in history ? Partly due to the loss, that same day two credit rating agencies reduced the bank's long term debt ratings: from AA to AA- by Fitch; and from Aa1/B to Aa2/B- by Moody's
How did it happen?
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It is not the role of Société Générale‘s Equities businesses to take directional positions on the equity markets (i.e. to speculate on rises or falls) The division where the trader worked is assigned to arbitrate financial instruments on European stock markets. This arbitrage business involves purchasing a portfolio of financial instruments A and selling at the same time a portfolio of financial instruments B with extremely similar characteristics, but with a slightly different value.
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Portfolios A and B have very similar characteristics and that they offset each other, means that these activities generate very little market risk. The trader inserted fictitious operations into portfolio B in order to give the impression that this portfolio genuinely offset portfolio A which he had purchased, when this was not the case The trader had taken fraudulent directional positions in 2007 and 2008 far beyond his limited authority on so-called ?plain vanilla? futures transactions Kerviel set up fictitious trades that cancelled out the risk from his huge bets on European stock market futures, covering up his true exposure to market movements
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In order to ensure that these fictitious operations were not immediately identified, the trader used his years of experience in processing and controlling market operations He ensured that the characteristics of the fictitious operations limited the chances of a control: for example he chose very specific operations with no cash movements or margin call and which did not require immediate confirmation
He falsified documents allowing him to justify the entry of fictitious operations
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He misappropriated the IT access codes belonging to operators in order to cancel certain operations
What went wrong??
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The increasing margin outflow and lack of compensating inflow were not picked up
It is general practice that all market trades are confirmed. this control is conducted by in middle or back office. When bank investigated about kerveil's fake trade, they were confronted with large number of unconfirmed contracts
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Kerviel took rarely any holidays and if he took he would not allow other to take his position. It is standard practice in most of the banks to enforce two week holiday rule ( specially for traders)
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The trader first spent five years working in different middleoffices (one of the departments which controls traders). Consequently, he had a very good understanding of all of Société Générale‘s processing and control procedures. Later he moved to arbitrage department. The Lagarde Report on fraud reveals the lack of employee control, security issues concerning the informational computerized system but also the lack of a management-alert mechanism concerning the transactions of individual traders.
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The Irony ? Only few hours after the announcement of historical 7 billion USD loss, Society General is named by risk magazine " equity derivative house of the year"
WHEN HUNTER GOT HUNTED
AMARANTH ADVISORS
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Year of Scam – 2006
Impact ( Total Loss) -$6 billion, the largest hedge fund collapse in history Derivative Instrument – Natural Gas Futures Key Person - Brian Hunter
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Amaranth Advisors LLC
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American multi-strategy hedge fund managing US $9 billion in assets
Founded by Nicholas Maounis and based in Greenwich, Connecticut "Amaranth" means "unfading" in Greek Firm's primary profit centre was ?Convertible arbitrage?
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Chronology of events
2000 ? As more and more capital began flowing into the convertible arbitrage strategy during the early 2000s, trading opportunities became more difficult to find. 2004-2005 ? By 2004-2005, the firm had shifted much of its capital to energy trading ? Energy desk was run by a Canadian trader named Brian Hunter who placed "spread trades" in the natural gas market ? Made enormous profits for the company by placing bullish bets on natural gas prices in 2005 ? Oil Prices were going up because Hurricane Katrina had severely affected natural gas production and refining capacity
Chronology of events
May 2006 ? Hoping for repeat performance, they leveraged their position 8:1 ? Amaranth went ?long? on March contracts and ?short? on April contracts August 2006 ? The spread between the March and April 2007 contracts was US $2.49
September 2006 ? At the end of September 2006 spread went down to US $0.58 ? The price decline was catastrophic for Amaranth, resulting in a loss of US$6.5 billion
Natural Gas at NYMEX
Chronology of events
September 20, 2006 ? Reuters reported that Amaranth would transfer its energy portfolio to a third party, eventually revealed to be Citadel Investment Group and JPMorgan Chase
September 29, 2006 ? The founder of Amaranth sent a letter to fund investors notifying them of the fund's suspension October 1, 2006 ? Amaranth hired the Fortress Investment Group to help liquidate its assets
What went wrong??
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Historically, the spread in future prices for the March and April contracts have not been easily predictable The spread is dependent on meteorological and socio-political events whose uncertainty makes the placing of such large bets a precarious matter In Mr. Hunter‘s words ?The cycles that play out in the oil market can take several years, whereas in natural gas, cycles take several months. Every time you think you know what these markets can do, something else happens.? If things are so unpredictable, Amaranth should have traded smaller whereas Mr Hunter had 50% of the $9 billion fund in play on natural gas
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What went Wrong?
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Backed by borrowed money and a deep-pocketed fund, Mr. Hunter took on more exposure to certain futures contracts than do some big investment banks employing more than 100 energy traders. He sometimes held open positions to buy or sell tens of billions of dollars of commodities.
Mr. Maounis said ?What Brian is really, really good at is taking controlled and measured risk.? But after Amaranth lost $ 6 billion, Hunter blamed it on unprecedented and unforeseen prices of natural gas.
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Key Learning
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Position Sizing: Position in a single instrument should be a small proportion of Fund‘s asset to avoid ?risk of ruin? Sound Risk management against unforeseen events
Do not borrow large amount of money for investing in unpredictable instruments Successful Traders May Require More, Not Less, Scrutiny
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When Genius failed
John Meriwether
Robert C. Merton
Myron Scholes
Long-term capital management
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Year – 1998 Country – US Amount lost – USD 4.6 billion Source of loss – Interest rate and equity derivatives Person associated – John Meriwether
About the company
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US Hedge Fund found in 1994 by John Meriwether Board of Directors included Myron Scholes and Robert C. Merton Began trading with $1,011,060,243 of investor capital Witnessed enormous initial success with annualized returns of over 40% in the first years
The business
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Fixed income arbitrage
Use of interest rate swaps, US – non US government bond arbitrage and forward yield curves
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Merger arbitrage
Buy target and short sell the acquirer
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Risk management techniques - VaR, stress testing and scenario analysis
10 percent loss in its portfolio was judged to be a three-standarddeviation event—an event that would occur once in a thousand or so trading periods
Chronology of events
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Jan 1998 : Long-Term Capital Management was of the world‘s most respected hedge funds
May 1998 : -6.42% returns
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Downturn in the mortgage-backed securities market forced some key hedge funds to liquidate their emerging-market positions. That led to a general widening of credit spreads LTCM reduced risk exposure from $45 million a day to $34 million. However the investments which were taken away were the least attractive and hence the most liquid
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June 1998 : -10.14% returns
Chronology of events
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July 1998 : exit of Salomon brothers from the arbitrage business
No other player stepped in to buy Salomon‘s positions
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Aug 1998 : Russian financial crisis
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The model had judged that kind of loss to be a 14-standard-deviation event, something that occurs once in several billion times the life of the universe. However, LTCM still believed that its trade looked good and over time, the credit spreads would have to return to normal. Fund was down by 44 percent On August 21 alone, the firm lost $550 million With only $2.3 billion equity left, the D:E ratio went to 43:1. Another $1.5 billion was required to improve it. LTCM was forced to reveal its positions to get the required capital.
Chronology of events
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Sept 1998 : LTCM's equity tumbled from $2.3 billion to $600 million
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D:E ratio more than 100:1 On September 23, 14 banks invested $3.6 billion in return for a 90 percent stake in the firm.
What went wrong?
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Unaware about market price dynamics
According to economic theory, a bond that is too cheap should attract buyers. But in a skittish market, lower prices can repel buyers.
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Over reliance on VAR Not selling its illiquid holdings early Relying on historical data Over-confidence in the face of market phenomena
In July and August 1998, LTCM‘s models were predicting a daily P&L volatility of $35 million. When actual volatility proved to be much higher, why didn‘t the firm modify or discard its models?
Learning from the disaster
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Use of risk limits Use of multiple risk management models Constant modification of theoretical models to them make compatible with real world
The Currency Derivatives Fiasco
Allfirst / Allied Irish Banks
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Year of Scam – 2002
Impact ( Total Loss) – USD 0.69 Billion Derivative Instrument - Foreign Exchange Options Key Person - John Rusnak
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About Allied Irish Bank
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Major commercial bank based in Ireland Revenue - € 4.868 billion (2007) Net Income - € 2.248 billion (2007) Employee – 24000
Divisions: ? Personal banking services ? Corporate banking services- international banking and treasury operations ? Stock broking services
Chronology of Events
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1993 : John Rusnak, who had been working for Chemical Bank in New York, joins First Maryland Bancorp as a foreign exchange trader 1999 Allfirst is formed from the merger of First Maryland Bancorp (in which AIB first took a stake in 1983) and Dauphin Deposit Corporation (which AIB acquired in 1997) June 2001 John Rusnak is promoted to managing director in charge of foreign exchange trading, in the ?global trading‘ division of the treasury funds management section, or front office Late December, 2001 Allfirst officials start to become suspicious about the sums being demanded by Rusnak to cover his trading
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February 4, 2002 Rusnak fails to show up for work on Monday morning
February 6 AIB says it is investigating a suspected $750 million fraud at Allfirst‘s Baltimore HQ, and warns that it will take a one-off charge of E596 million ($520 million) to cover the resulting losses
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February 19 AIB chief executive Michael Buckley says that the origins of the scandal might stretch back to 1997, and gives the final figure for losses as $691 million March 12 Buckley and AIB chairman Lochlann Quinn offer their resignations to the AIB board, but neither resignation is accepted
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How did it happen?
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The main business of Rusnak was to carry out arbitrage between foreign exchange option and the spot and forward forex markets i.e. buying options when they were cheap and selling them when they were expensive
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However, It was found that much of Rusnak‘s trading involved simply taking directional bets on the movement of the market, using simple currency forwards. He then created fictitious options positions in order to hide his losses, which gave the impression that his real positions were hedged..
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Mr. Rusnak placed large sum one-way bets that the yen would increase in value against the dollar.
As the yen declined, he could not go back on the forward contracts as they are binding, and was forced to take his losses. He did not hedge these bets with options contracts At the end of 1997, John Rusnak had lost $29.1 million by his wrong bets in trading.Instead of taking responsibility and reporting his losses immediately, he decided to hide them, buy himself some time and see if he could win back the money he had lost He used many complicated schemes to hide his losses like falsification of documents, misuse of office technology, fraudulent entries in accounting systems
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Bogus Options ? At the end of his trading day, when Mr. Rusnak was entering his daily trades in the bank system, he would enter two false trades that would offset each other ? They were for the same amounts of currencies and used the same strike price with same premium. The expiry dates on the options were different. ? The first option would allow the Japanese bank to sell yen at a certain strike price. This option would expire on the day it was written. ( Deep in Money Option) ? Other option is a call option written by the Japanese bank to buy yen at the same strike price as the other option. This option would expire months in the future. ? The put option would disappear off the books the next day, removing that liability from the banks records. The call option would stay on the books as a valuable asset that covered his losses
Falsified documents
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John Rusnak knew that the Treasury back office was going to need to confirm his trades He used his PC to create false trade confirmation documentation. His PC was discovered to have a directory called ?fake docs?. This directory contained logos and stationary from various banks in Tokyo and Singapore. Mr. Rusnak used these files to construct fake confirmation documents on his computer.
Prime Brokerage accounts
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Prime brokerage accounts are typically used by high profile traders which are provided with net settlements where Daily spot transactions were rolled into one forward transaction to be settled at a future date with the prime broker. In 1999, with $41.5 million lost, John Rusnak turned to prime brokerage accounts. Having all the daily spot transactions rolled into one net settlement meant that the Treasury back office could not track his daily trades as effectively. These accounts enabled Mr Rusnak to increase significantly the size and scope of his real trading.
Value at Risk calculations
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John Rusnak avoided detection by manipulating the bank‘s Value at Risk (VaR) calculations. The VaR is the largest amount of money the bank can afford to lose if there are adverse trading conditions.For John Rusnak, the VaR was $1.5 million. As of the end of 1999, Rusnak had lost $90 million A trader is responsible for calculating and monitoring their own VaR. The VaR is also independently calculated by Treasury risk control as a check on the trader. He was able to convince the risk control group to accept a spreadsheet of his open currency positions from him with no confirmation.
Sale of options ? John Rusnak needed large amounts of cash to continue his gamble to win back the money he had lost. ? To get around , He sold deep-in-the-money options at high premiums to finance his trading. The options he sold had deep-in-the money strike prices. The strike prices were so deep, it was extremely likely that the options would be exercised. ? They were European options that expired in a year and a day. ? They were essentially loans from the counterparties to Allfirst, to John Rusnak. He received millions of dollars in premiums for the options. ? As an example, in February 2001, Rusnak made an agreement with Citibank. For a premium of $125 million, Rusnak wrote a put that gave Citibank the right to sell yen at a strike rate of 77.37 yen to the dollar. The exchange rate at the timewas 116 yen to the dollar.
What went wrong?
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Anyone who really looked at the options would have questioned the fact that the two options had different expiry dates but the same premium. The put option was a deep-in-the-money option. The holder of the option would make a profit by exercising it. The option went off the books in one day unexercised. That was unusual. Rusnak was able to convince the back office to not confirm the trades at all. He was able to argue that since the trades netted to zero, they did not need to be confirmed. He convinced David Cronin, the Allfirst Treasurer, that the prime brokerage accounts would relieve the back office of the extra work they needed to do on his behalf. John Rusnak used the prime brokerage accounts as another opportunity to enter fictitious trades.
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He was able to convince the risk control group to accept a spreadsheet of his open currency positions from him with no confirmation. He altered the values in this spreadsheet to make his open positions seem less than they were. At one point, the bank gave Mr. Rusnak Travel Bloomberg software so that he could trade from home and while on vacation. This was a direct violation of U.S. law. U. S. law requires that traders take 10 consecutive days off from trading every year
A tale of two scams
Union Bank of Switzerland
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Year – 1998 Country – Switzerland Amount lost – USD 1.18 billion Source of loss – Equity Derivatives People associated – Ramy Goldstein and Mathis Cabiallavetta
About the company
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Found in 1912 Merged with Swiss Bank Corporation in 1998 to become UBS AG
GED (Global equity derivatives)
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Business headed by Ramy Goldstein from 1991 A team of 140 employees GED was entirely independent of the bank yet had access to its capital. In 1996, profit from GED was 270 million Swiss Franc, 15% of profit of entire bank with 28,000 employees Goldstein had his own risk management unit to estimate and control the risk on all deals in the department.
Risk Management
Mathis Cabiallavetta (CEO)
Werner Bonadurer (Head – Trading Group)
Steven Schulman (Risk Manager – GED)
Ramy Goldstein (Head - GED)
Chronology of events
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1996 - Goldstein had become the bank's shining star and highest-paid employee. His bonus for 1996 was approximately 15 million Swiss francs, or $11,481,000.
Mid 1996 – Taking High Risks
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GED wrote many long-dated options, some longer than five years, which were difficult to calculate even with the most complex models. GED bought convertible bonds from Japanese banks in large quantities. The bond piece was sold off and the bank retained the option to buy the stock. And Goldstein's group immediately entered the profits in its books on options with five-year expiries.
Chronology of events
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August 1996 – Crisis in Japan
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Japanese bank stocks down by 70 percent Price of options plummeted
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1997 – Another blunder
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Losses from trades of GED continued UBS wrote a seven-year call option, or warrant for LTCM on their own company. It purchased about $800 million worth of shares in the company to hedge the call option it sold.
Chronology of events
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About the LTCM-UBS deal
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The trade was approved at the highest level of management within UBS—the CEO, the head of credit and the head of the derivatives group. The strike price of the option was set at $575 million which was 80 percent of the forward value of LTCM. UBS needed to purchase $525 million in shares to cover its trade. The bank purchased an additional $275 million in LTCM shares since senior management of UBS believed strongly in LTCM
Chronology of events
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Nov 1998 – Bank announced dismissal of Goldstein
Jan 1998 – Bank announced losses of $239 million from operations of GED (which was later increased to $500 million) June 1998 – Union Bank of Switzerland merged with Swiss Bank Corporation to from UBS AG Oct 1998 – $680 million loss from deal with LTCM
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What went wrong?
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Goldstein's belief in autonomy was accepted and encouraged at the top. Risk monitoring at UBS was not independent. Lack of experienced personnel Politics within the organization
Learning from the disaster
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Independent and Efficient Risk Control Mechanisms Check and limit on trading activities Banks should not possess a large and relatively illiquid hedge fund investments in their Treasury Account
THE RISE AND FALL OF ?COPPER MAN?
SUMITOMO CORPORATION
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Year of Scam – 1996
Impact ( Total Loss) -$ 2.6 billion, largest unauthorized trading loss Derivative Instrument – Copper Futures Key Person – Yasuo Hamanaka
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About Sumitomo
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Sumitomo was initially established as ?Osaka Hokko Kaisha Limited? in December 1919 with a capital of 35 million yen The company entered into the trading business in 1945 with a new name ?Nihon Kensetsu Sangyo Kaisha Limited? In 1973, it got listed on the Frankfurt Stock exchange and in 1978 it adopted the name ?Sumitomo Corporation? Sumitomo consists of six corporate groups, nine business units and twentyeight business divisions The company has nine business divisions - Iron & Steel, Nonferrous Metals, Electric, Machinery, Produce & Fertilizer, Chemicals, Textile, General Products & Fuel and Real Estate
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Chronology of events
1985 ? Hamanaka started off-the-balance-sheet trading in 1985 with Saburo Shimizu, his former boss and then leader of Sumitomo's copper trading team, accumulating losses of 6.5 billion yen by the time Shimizu quit the firm in 1987 ? On taking charge of the copper trading team, Hamanaka tried to recover the losses by taking huge positions in copper commodity futures on the London Metal Exchange 1988 ? The huge volume of trading attracted the attention of the exchange and it gave a warning to Hamanaka. ? Hamanaka then struck a deal with Merrill Lynch for US $150 mn, which enabled him to trade via Merrill at LME
1990 ? Hamanaka borrowed money from several banks without any authorization from his seniors. ? He used the funds either to buy copper or pay for the collateral that he was required to deposit at the LME to cover loss-making positions ? Hamanaka was reporting huge trading profits to the top management by showing invoices of fictitious option trades, which he had created through a nexus with some brokers 1993-1994 ? Hamanaka forged the signatures of his superiors on four documents to keep his off-the-book trading from being discovered by Sumitomo and his clients
Chronology of events
1994 ? An unnamed Merrill managing director devised a plan whereby Sumitomo and Global Minerals & Metals Corp, New York opened an account in the name of Sumitomo, in which Global would have trading authority, but which was backed by Sumitomo's credit
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Hamanaka began to purchase "long" forward copper positions on the London Metal Exchange (betting that copper prices would rise), primarily through a Merrill account Together with Sumitomo's long positions at Merrill, and also at other brokers, Sumitomo and Global held 1.35 million metric tons of London Metal Exchange forward copper contracts Global and Sumitomo's warrant-taking operation was motivated by their intention to manipulate prices and spread, not by genuine commercial need, and they were attempting to manipulate, and were successfully manipulating the world's copper markets
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Copper price at LME
Chronology of events
December 1995 ? But laws of supply and demand cannot be manipulated for long. Regulators eventually started probing the case. ? After knowing that Mr. Hamanaka had manipulated the market into an artificially high zone, hedge funds and other short-sellers came into act and causing the Copper prices to fall on London Metal Exchange
June 13, 1996 ? Sumitomo Corp. discloses that it had lost $1.8 billion in copper trading on LME
Chronology of events
September 1996 ? Sumitomo disclosed the revised loss figure of $2.6 bn represented about 10% of Sumitomo's annual sales
October 1996 ? Japanese authorities arrest Mr. Hamanaka on charges he forged documents involving trades with Merrill Lynch and other metalstrading firms May 1998 ? Sumitomo consents to pay $125 million to settle case with Commodity Futures Trading Commission.
What went wrong??
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Debacle was the result of Sumitomo's poor managerial, financial and operational control systems. Due to this, Hamanaka was able to carry on unauthorized trading activities undetected by the top management The vesting of excessive decision power on a single employee and failure to implement the job rotation policy By entering into fictitious trades and manipulating accounts, Hamanaka successfully misled the management to believe that he was making huge profits
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Key Learning
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Do not vest excessive decision on a single employee Sound operational and monitoring system should be in place Successful Traders May Require More, Not Less, Scrutiny
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Metallgesellschaft Failed Hedge…
Metallgesellschaft
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Year of Scam – 1993
Impact ( Total Loss) – USD 1.96 Billion Derivative Instrument - Oil Futures
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Key Person - Heinz Schimmelbusch
About Metallgesellschaft
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one of Germany's largest industrial conglomerates based in Frankfurt Revenue - 10 billion US dollars
Employee – 20000 Engaged in wide range of activities, from mining and engineering to trade and financial services
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How did it happen?
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Around 1993, MG‘s trading subsidiary, MG Refining and Marketing (MGRM) offered several novel programs like - ?firm-fixed? program under which the customer would agree to a fixed monthly delivery of oil products at a set price -?firm-flexible? program which specified a fixed price and total volume of future deliveries but gave the customer some flexibility to set the delivery schedule In 1993, MG Refining and Marketing (MGRM), established very large energy derivatives (futures and swaps) positions to hedge its price exposure on its forward-supply contracts to deliver gasoline, diesel fuel and heating oil (about 160 million barrels) to its customers over a period of ten years at fixed prices.
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Most of the forward contracts were negotiated during the summer of 1993 when energy prices were low and falling and the contracts came with cash-out option if the energy price were to rise above the contractually fixed prices.
MGRM hedged this price risk with energy futures contracts of between one to three months to maturity at NYMEX and OTC swaps to protect the profit margins in its forward delivery contracts by insulating them from increases in energy prices. MGRM would gain substantially from its derivative positions if the energy prices rise. During the later part of 1993, however, energy prices fell sharply resulting in unrealized losses and margin calls on derivative positions in excess of $900 million.
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MGRM‘s hedging strategy included short-dated energy futures contracts and OTC swaps – a ?stack and roll? or ?rolling stack? strategy.
Under this strategy, MGRM opened a long position in futures staked in the near month contract. Each month MGRM would roll the stack over into the next near month contract, gradually decreasing the size of the position. Under this plan the total long position in the stack would always match the short position remaining due under the supply contracts. A stack hedge refers to a futures position being ?stacked? or concentrated in a particular delivery month (or months) rather than being spread over many delivery months. This exposed the firm to rollover risk.
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The stack and roll strategy can be profitable when markets are in ?backwardation,? that is, when spot prices are higher than futures prices.But when markets are in ?contango,? when futures prices are higher than spot prices, the strategy will result in losses.
MGRM failed to factor the rollover risk (that arises from the contango) into the price of the call options within forward fixed-rate contracts. This rollover loss was the real economic loss that MGRM suffered, i.e. they were unrecoverable. According to an MG spokesperson, hedge positions position was the equivalent of 85 days worth of the entire off output of Kuwait. If oil prices were to drop, MGRM would lose money on their hedge positions and would receive margin calls on their futures positions.
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Although gains in the forward contract positions would offset the hedge losses, a negative cash flow would occur in the short run because no cash would be received for the gain in the value of the forwar contracts until the oil was sold.
MGRM‘s strategy exposed it to three significant and related risks: rollover risk, funding risk, and credit risk, because of the maturity mismatch between the hedge and the delivery contracts and other features. It was exposed to rollover risk because of uncertainty about whether it would sustain gains or losses when rolling its derivatives position forward. It is exposed to funding risk because of the marked-to-market conventions that applied to its short-dated derivative‘s position.
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It is exposed to credit risk because of its forward delivery counter-parties might default on their long-dated obligations to purchase oil at fixed prices. When the oil price fell yet more precipitously at the end of the 1993, the company did not have sufficient cash to continue to roll over its stack of oil futures contracts as planned and could not meet a large number of its other obligations until it received an emergency line of credit from its bankers. Losses eventually totaled nearly $1.3 billion. By January 1994 the firm was close to declaring bankruptcy and its future was not clear.
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What went wrong?
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The average trading volume in the heating oil and unleaded gasoline pits usually averages anywhere from 15,000 to 30,000 contracts per day. With MGRM reportedly holding a 55,000 contract position in these contracts. The exchange market simply could not handle an effective hedge with a position so large and out of character. It created a funding risk for MGRM that proved enormous. Wrong assumptions of the architects of MGRM‘s hedging strategy made regarding the likely future behavior of basis in oil futures and forward markets (backwardation) No steps are taken by MGRM to reduce the variability of its cash flows
The deception
China Aviation Oil (CAO)
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Year – 2004 Country – China Amount lost – USD 0.55 billion Source of loss – Oil Options Person associated – Chen Juilin
About the company
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Incorporated in 1993
Dealt with the procurement of jet fuel for airports in China Had a 100% market share of the procurement of imported jet fuel for China's civil aviation industry Initially, started trading of swaps and futures Later, entered into speculative trading in fuel options
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Valuation of options
Option Fair Value = Intrinsic Value + Time Value
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The Intrinsic Value is the value of the option if it would expire today (e.g. for a call option it is Max(0,S-K)). The Time Value reflects the value of the volatility of the market
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Moneyness of options
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ATM: At-the-money
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An option is ATM if the strike price is the same as the current price of the underlying security No intrinsic value, only time value
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ITM: In-the-money
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Positive intrinsic value as well as time value. A call option is ITM when the strike price is below the current trading price. A put option is ITM when the strike price is above the current trading price.
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OTM: Out-of-the-money
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No intrinsic value. A call option is OTM when the strike price is above the current trading price A put option is OTM when the strike price is below the current trading price
What happened at CAO?
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Starting Q3 2003, CAO took a bearish view on oil markets
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Consistent with this view, CAO sold call options and purchased put options on Jet Fuel
These options were valued in their profit & loss accounts based on the Intrinsic Value only (i.e. not taking into account the Time Value) With the market moving against their position, CAO restructured their books at 3 different times by repurchasing the call options sold earlier and selling call options with a longer maturity. With oil prices continuing to rise, CAO could not satisfy the resulting cash (margin) calls from the call option buyers and had no choice but to go public with their results.
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Simplification of CAO‘s trading strategy
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Action 1: On 1st October 2003 the company sold 100 OTM call option with expiry 1st April 2004
Action 2: On 1st March 2004 the company repurchased the April 04 option and sold an OTM call option with expiry 1st July 2004 Action 3: On 1st June 2004 the company repurchased the July 04 option and sold an OTM call option with expiry 1st November 2004; Action 4: On 1st October 2004 the company repurchased the November 04 option and sold an OTM call option with expiry 1st January 2005.
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Simplification of CAO‘s trading strategy
Oil Futures prices and timing of CAO’s actions
Simplification of CAO‘s trading strategy
Estimated Income from the options strategy
(P&L X refers to CAO’s P&L)
What went wrong?
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The speculative option trading started without it being properly encapsulated in risk management policies and senior management oversight.
The option contracts were not valued on a best practice basis. In particular, time value was not considered. The company stuck to its valuation approach, despite the confirmations received from the counterparties that contained significantly different prices.
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The errors in the valuation of the open position, led to erroneous financial statements.
There were several roll-overs of loss generating positions, whereby options on bigger volumes were sold to generate sufficient cash to settle the losses on an existing position.
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Lessons learned
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Derivative mishaps are not due to inherent dangerous character of instruments, but due to ill-conceived and poorly defined strategies Hence, good Governance and Risk management systems are necessary for the businesses active in financial derivatives Well defined rules in financial management activities to create accountability
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Almost a text book example of what NOT to do in derivatives business …
Barings Bank
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A 233 year old institution, England‘s oldest merchant bank Year of Scam – 1995
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Impact ( Total Loss) -$1.4 billion
Derivative Instrument – Japan Index Futures Key Person – Nick Lesson Original strategy – Nikkei 225 arbitrage between SIMEX and OSE
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Chronology of Events
1992 Lesson becomes the head of settlements for Barings Future Singapore 1994 Lesson becomes head of trading floor too – derivative profit from $2 mn to $20 mn End of January 1995 From hedging to gambling January 17 1995 Kobe earthquake and Nikkei wobbles
January 20 ? Lesson buys 11,000 Nikkei contracts
January 17 – January 23 ? Piling up of Nikkei futures to keep Nikkei above 18500 to keep 40,000 outstanding options contract profitable
January 23 ? Tokyo stock market plunges 1000 points to under 17,800
January 23 – February 23 ? Lesson tries to run upstream and losses keep on mounting ? Dual role of Lesson and loose internal control helped him to disguise all losses under A/c : 88888
February 23 ? Outstanding index futures position reaches $7 bn
February 25 - 26 ? Attempts to raise enough private money before market opens on Monday
February 26 ? Barings Plc declared bankruptcy
Where lies the onus?
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The rogue trader :
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From index futures arbitrage to straddles Head of trading floor and the head of settlement – dissolving the Chinese wall
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Bank’s aristocratic management:
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No management control and internal control No clear segregation of duties Huge margin calls from SIMEX and OSE – did management actually understand the derivative business?
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The Exchanges – SIMEX and OSE
THANK YOU
doc_226808424.ppt
This is a presentation describes various disasters which happened because of derivatives.
Derivatives Disasters
Presented By: Group I MBA (II) Finance 16th August,2008
It can‘t get bigger…
Société Générale
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Year of Scam – 2008
Impact ( Total Loss) -$7 billion, the biggest loss ever recorded in the financial industry by a single trader Derivative Instrument - European Index Futures
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Key Person - Jérôme Kerviel
About Société Générale
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One of the oldest banks in France established in 1864 Revenue - € 21.923 billion (2007) Net Income - € 1.604 billion (2007) Employee - 130,100 (2007) In 77 countries worldwide
Divisions: ? Retail Banking & Specialized Financial Services ? Corporate and Investment Banking ? Global Investment
Chronology of Events
Friday January 18th ? Abnormal counterparty risk on a broker is detected several days earlier. The explanations provided by the trader result in additional controls. ? In the afternoon of January 18th, it appears that the counterparty for the recorded operations is in fact a large bank, but the confirmation e-mail raises suspicions. Investigation for the same started Saturday January 19th ? The large bank in question does not recognise the operations ? The trader finally acknowledges committing unauthorised acts creating fictitious operations
Sunday January 20th ? All of the positions are identified and the extent of the total exposure is known Monday January 21st ? The unwinding of the fraudulent position begins in particularly unfavourable market conditions Wednesday January 23rd ? The unwinding of the fraudulent position is completed Thursday January 24th ? Bank announced that a single futures trader at the bank had fraudulently lost the bank 4.9 billion € (an equivalent of 7.2 billion dollars), the largest such loss in history ? Partly due to the loss, that same day two credit rating agencies reduced the bank's long term debt ratings: from AA to AA- by Fitch; and from Aa1/B to Aa2/B- by Moody's
How did it happen?
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It is not the role of Société Générale‘s Equities businesses to take directional positions on the equity markets (i.e. to speculate on rises or falls) The division where the trader worked is assigned to arbitrate financial instruments on European stock markets. This arbitrage business involves purchasing a portfolio of financial instruments A and selling at the same time a portfolio of financial instruments B with extremely similar characteristics, but with a slightly different value.
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Portfolios A and B have very similar characteristics and that they offset each other, means that these activities generate very little market risk. The trader inserted fictitious operations into portfolio B in order to give the impression that this portfolio genuinely offset portfolio A which he had purchased, when this was not the case The trader had taken fraudulent directional positions in 2007 and 2008 far beyond his limited authority on so-called ?plain vanilla? futures transactions Kerviel set up fictitious trades that cancelled out the risk from his huge bets on European stock market futures, covering up his true exposure to market movements
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In order to ensure that these fictitious operations were not immediately identified, the trader used his years of experience in processing and controlling market operations He ensured that the characteristics of the fictitious operations limited the chances of a control: for example he chose very specific operations with no cash movements or margin call and which did not require immediate confirmation
He falsified documents allowing him to justify the entry of fictitious operations
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He misappropriated the IT access codes belonging to operators in order to cancel certain operations
What went wrong??
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The increasing margin outflow and lack of compensating inflow were not picked up
It is general practice that all market trades are confirmed. this control is conducted by in middle or back office. When bank investigated about kerveil's fake trade, they were confronted with large number of unconfirmed contracts
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Kerviel took rarely any holidays and if he took he would not allow other to take his position. It is standard practice in most of the banks to enforce two week holiday rule ( specially for traders)
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The trader first spent five years working in different middleoffices (one of the departments which controls traders). Consequently, he had a very good understanding of all of Société Générale‘s processing and control procedures. Later he moved to arbitrage department. The Lagarde Report on fraud reveals the lack of employee control, security issues concerning the informational computerized system but also the lack of a management-alert mechanism concerning the transactions of individual traders.
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The Irony ? Only few hours after the announcement of historical 7 billion USD loss, Society General is named by risk magazine " equity derivative house of the year"
WHEN HUNTER GOT HUNTED
AMARANTH ADVISORS
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Year of Scam – 2006
Impact ( Total Loss) -$6 billion, the largest hedge fund collapse in history Derivative Instrument – Natural Gas Futures Key Person - Brian Hunter
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Amaranth Advisors LLC
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American multi-strategy hedge fund managing US $9 billion in assets
Founded by Nicholas Maounis and based in Greenwich, Connecticut "Amaranth" means "unfading" in Greek Firm's primary profit centre was ?Convertible arbitrage?
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Chronology of events
2000 ? As more and more capital began flowing into the convertible arbitrage strategy during the early 2000s, trading opportunities became more difficult to find. 2004-2005 ? By 2004-2005, the firm had shifted much of its capital to energy trading ? Energy desk was run by a Canadian trader named Brian Hunter who placed "spread trades" in the natural gas market ? Made enormous profits for the company by placing bullish bets on natural gas prices in 2005 ? Oil Prices were going up because Hurricane Katrina had severely affected natural gas production and refining capacity
Chronology of events
May 2006 ? Hoping for repeat performance, they leveraged their position 8:1 ? Amaranth went ?long? on March contracts and ?short? on April contracts August 2006 ? The spread between the March and April 2007 contracts was US $2.49
September 2006 ? At the end of September 2006 spread went down to US $0.58 ? The price decline was catastrophic for Amaranth, resulting in a loss of US$6.5 billion
Natural Gas at NYMEX
Chronology of events
September 20, 2006 ? Reuters reported that Amaranth would transfer its energy portfolio to a third party, eventually revealed to be Citadel Investment Group and JPMorgan Chase
September 29, 2006 ? The founder of Amaranth sent a letter to fund investors notifying them of the fund's suspension October 1, 2006 ? Amaranth hired the Fortress Investment Group to help liquidate its assets
What went wrong??
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Historically, the spread in future prices for the March and April contracts have not been easily predictable The spread is dependent on meteorological and socio-political events whose uncertainty makes the placing of such large bets a precarious matter In Mr. Hunter‘s words ?The cycles that play out in the oil market can take several years, whereas in natural gas, cycles take several months. Every time you think you know what these markets can do, something else happens.? If things are so unpredictable, Amaranth should have traded smaller whereas Mr Hunter had 50% of the $9 billion fund in play on natural gas
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What went Wrong?
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Backed by borrowed money and a deep-pocketed fund, Mr. Hunter took on more exposure to certain futures contracts than do some big investment banks employing more than 100 energy traders. He sometimes held open positions to buy or sell tens of billions of dollars of commodities.
Mr. Maounis said ?What Brian is really, really good at is taking controlled and measured risk.? But after Amaranth lost $ 6 billion, Hunter blamed it on unprecedented and unforeseen prices of natural gas.
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Key Learning
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Position Sizing: Position in a single instrument should be a small proportion of Fund‘s asset to avoid ?risk of ruin? Sound Risk management against unforeseen events
Do not borrow large amount of money for investing in unpredictable instruments Successful Traders May Require More, Not Less, Scrutiny
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When Genius failed
John Meriwether
Robert C. Merton
Myron Scholes
Long-term capital management
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Year – 1998 Country – US Amount lost – USD 4.6 billion Source of loss – Interest rate and equity derivatives Person associated – John Meriwether
About the company
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US Hedge Fund found in 1994 by John Meriwether Board of Directors included Myron Scholes and Robert C. Merton Began trading with $1,011,060,243 of investor capital Witnessed enormous initial success with annualized returns of over 40% in the first years
The business
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Fixed income arbitrage
Use of interest rate swaps, US – non US government bond arbitrage and forward yield curves
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Merger arbitrage
Buy target and short sell the acquirer
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Risk management techniques - VaR, stress testing and scenario analysis
10 percent loss in its portfolio was judged to be a three-standarddeviation event—an event that would occur once in a thousand or so trading periods
Chronology of events
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Jan 1998 : Long-Term Capital Management was of the world‘s most respected hedge funds
May 1998 : -6.42% returns
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Downturn in the mortgage-backed securities market forced some key hedge funds to liquidate their emerging-market positions. That led to a general widening of credit spreads LTCM reduced risk exposure from $45 million a day to $34 million. However the investments which were taken away were the least attractive and hence the most liquid
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June 1998 : -10.14% returns
Chronology of events
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July 1998 : exit of Salomon brothers from the arbitrage business
No other player stepped in to buy Salomon‘s positions
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Aug 1998 : Russian financial crisis
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The model had judged that kind of loss to be a 14-standard-deviation event, something that occurs once in several billion times the life of the universe. However, LTCM still believed that its trade looked good and over time, the credit spreads would have to return to normal. Fund was down by 44 percent On August 21 alone, the firm lost $550 million With only $2.3 billion equity left, the D:E ratio went to 43:1. Another $1.5 billion was required to improve it. LTCM was forced to reveal its positions to get the required capital.
Chronology of events
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Sept 1998 : LTCM's equity tumbled from $2.3 billion to $600 million
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D:E ratio more than 100:1 On September 23, 14 banks invested $3.6 billion in return for a 90 percent stake in the firm.
What went wrong?
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Unaware about market price dynamics
According to economic theory, a bond that is too cheap should attract buyers. But in a skittish market, lower prices can repel buyers.
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Over reliance on VAR Not selling its illiquid holdings early Relying on historical data Over-confidence in the face of market phenomena
In July and August 1998, LTCM‘s models were predicting a daily P&L volatility of $35 million. When actual volatility proved to be much higher, why didn‘t the firm modify or discard its models?
Learning from the disaster
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Use of risk limits Use of multiple risk management models Constant modification of theoretical models to them make compatible with real world
The Currency Derivatives Fiasco
Allfirst / Allied Irish Banks
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Year of Scam – 2002
Impact ( Total Loss) – USD 0.69 Billion Derivative Instrument - Foreign Exchange Options Key Person - John Rusnak
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About Allied Irish Bank
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Major commercial bank based in Ireland Revenue - € 4.868 billion (2007) Net Income - € 2.248 billion (2007) Employee – 24000
Divisions: ? Personal banking services ? Corporate banking services- international banking and treasury operations ? Stock broking services
Chronology of Events
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1993 : John Rusnak, who had been working for Chemical Bank in New York, joins First Maryland Bancorp as a foreign exchange trader 1999 Allfirst is formed from the merger of First Maryland Bancorp (in which AIB first took a stake in 1983) and Dauphin Deposit Corporation (which AIB acquired in 1997) June 2001 John Rusnak is promoted to managing director in charge of foreign exchange trading, in the ?global trading‘ division of the treasury funds management section, or front office Late December, 2001 Allfirst officials start to become suspicious about the sums being demanded by Rusnak to cover his trading
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February 4, 2002 Rusnak fails to show up for work on Monday morning
February 6 AIB says it is investigating a suspected $750 million fraud at Allfirst‘s Baltimore HQ, and warns that it will take a one-off charge of E596 million ($520 million) to cover the resulting losses
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February 19 AIB chief executive Michael Buckley says that the origins of the scandal might stretch back to 1997, and gives the final figure for losses as $691 million March 12 Buckley and AIB chairman Lochlann Quinn offer their resignations to the AIB board, but neither resignation is accepted
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How did it happen?
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The main business of Rusnak was to carry out arbitrage between foreign exchange option and the spot and forward forex markets i.e. buying options when they were cheap and selling them when they were expensive
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However, It was found that much of Rusnak‘s trading involved simply taking directional bets on the movement of the market, using simple currency forwards. He then created fictitious options positions in order to hide his losses, which gave the impression that his real positions were hedged..
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Mr. Rusnak placed large sum one-way bets that the yen would increase in value against the dollar.
As the yen declined, he could not go back on the forward contracts as they are binding, and was forced to take his losses. He did not hedge these bets with options contracts At the end of 1997, John Rusnak had lost $29.1 million by his wrong bets in trading.Instead of taking responsibility and reporting his losses immediately, he decided to hide them, buy himself some time and see if he could win back the money he had lost He used many complicated schemes to hide his losses like falsification of documents, misuse of office technology, fraudulent entries in accounting systems
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Bogus Options ? At the end of his trading day, when Mr. Rusnak was entering his daily trades in the bank system, he would enter two false trades that would offset each other ? They were for the same amounts of currencies and used the same strike price with same premium. The expiry dates on the options were different. ? The first option would allow the Japanese bank to sell yen at a certain strike price. This option would expire on the day it was written. ( Deep in Money Option) ? Other option is a call option written by the Japanese bank to buy yen at the same strike price as the other option. This option would expire months in the future. ? The put option would disappear off the books the next day, removing that liability from the banks records. The call option would stay on the books as a valuable asset that covered his losses
Falsified documents
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John Rusnak knew that the Treasury back office was going to need to confirm his trades He used his PC to create false trade confirmation documentation. His PC was discovered to have a directory called ?fake docs?. This directory contained logos and stationary from various banks in Tokyo and Singapore. Mr. Rusnak used these files to construct fake confirmation documents on his computer.
Prime Brokerage accounts
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Prime brokerage accounts are typically used by high profile traders which are provided with net settlements where Daily spot transactions were rolled into one forward transaction to be settled at a future date with the prime broker. In 1999, with $41.5 million lost, John Rusnak turned to prime brokerage accounts. Having all the daily spot transactions rolled into one net settlement meant that the Treasury back office could not track his daily trades as effectively. These accounts enabled Mr Rusnak to increase significantly the size and scope of his real trading.
Value at Risk calculations
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John Rusnak avoided detection by manipulating the bank‘s Value at Risk (VaR) calculations. The VaR is the largest amount of money the bank can afford to lose if there are adverse trading conditions.For John Rusnak, the VaR was $1.5 million. As of the end of 1999, Rusnak had lost $90 million A trader is responsible for calculating and monitoring their own VaR. The VaR is also independently calculated by Treasury risk control as a check on the trader. He was able to convince the risk control group to accept a spreadsheet of his open currency positions from him with no confirmation.
Sale of options ? John Rusnak needed large amounts of cash to continue his gamble to win back the money he had lost. ? To get around , He sold deep-in-the-money options at high premiums to finance his trading. The options he sold had deep-in-the money strike prices. The strike prices were so deep, it was extremely likely that the options would be exercised. ? They were European options that expired in a year and a day. ? They were essentially loans from the counterparties to Allfirst, to John Rusnak. He received millions of dollars in premiums for the options. ? As an example, in February 2001, Rusnak made an agreement with Citibank. For a premium of $125 million, Rusnak wrote a put that gave Citibank the right to sell yen at a strike rate of 77.37 yen to the dollar. The exchange rate at the timewas 116 yen to the dollar.
What went wrong?
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Anyone who really looked at the options would have questioned the fact that the two options had different expiry dates but the same premium. The put option was a deep-in-the-money option. The holder of the option would make a profit by exercising it. The option went off the books in one day unexercised. That was unusual. Rusnak was able to convince the back office to not confirm the trades at all. He was able to argue that since the trades netted to zero, they did not need to be confirmed. He convinced David Cronin, the Allfirst Treasurer, that the prime brokerage accounts would relieve the back office of the extra work they needed to do on his behalf. John Rusnak used the prime brokerage accounts as another opportunity to enter fictitious trades.
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He was able to convince the risk control group to accept a spreadsheet of his open currency positions from him with no confirmation. He altered the values in this spreadsheet to make his open positions seem less than they were. At one point, the bank gave Mr. Rusnak Travel Bloomberg software so that he could trade from home and while on vacation. This was a direct violation of U.S. law. U. S. law requires that traders take 10 consecutive days off from trading every year
A tale of two scams
Union Bank of Switzerland
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Year – 1998 Country – Switzerland Amount lost – USD 1.18 billion Source of loss – Equity Derivatives People associated – Ramy Goldstein and Mathis Cabiallavetta
About the company
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Found in 1912 Merged with Swiss Bank Corporation in 1998 to become UBS AG
GED (Global equity derivatives)
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Business headed by Ramy Goldstein from 1991 A team of 140 employees GED was entirely independent of the bank yet had access to its capital. In 1996, profit from GED was 270 million Swiss Franc, 15% of profit of entire bank with 28,000 employees Goldstein had his own risk management unit to estimate and control the risk on all deals in the department.
Risk Management
Mathis Cabiallavetta (CEO)
Werner Bonadurer (Head – Trading Group)
Steven Schulman (Risk Manager – GED)
Ramy Goldstein (Head - GED)
Chronology of events
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1996 - Goldstein had become the bank's shining star and highest-paid employee. His bonus for 1996 was approximately 15 million Swiss francs, or $11,481,000.
Mid 1996 – Taking High Risks
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GED wrote many long-dated options, some longer than five years, which were difficult to calculate even with the most complex models. GED bought convertible bonds from Japanese banks in large quantities. The bond piece was sold off and the bank retained the option to buy the stock. And Goldstein's group immediately entered the profits in its books on options with five-year expiries.
Chronology of events
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August 1996 – Crisis in Japan
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Japanese bank stocks down by 70 percent Price of options plummeted
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1997 – Another blunder
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Losses from trades of GED continued UBS wrote a seven-year call option, or warrant for LTCM on their own company. It purchased about $800 million worth of shares in the company to hedge the call option it sold.
Chronology of events
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About the LTCM-UBS deal
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The trade was approved at the highest level of management within UBS—the CEO, the head of credit and the head of the derivatives group. The strike price of the option was set at $575 million which was 80 percent of the forward value of LTCM. UBS needed to purchase $525 million in shares to cover its trade. The bank purchased an additional $275 million in LTCM shares since senior management of UBS believed strongly in LTCM
Chronology of events
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Nov 1998 – Bank announced dismissal of Goldstein
Jan 1998 – Bank announced losses of $239 million from operations of GED (which was later increased to $500 million) June 1998 – Union Bank of Switzerland merged with Swiss Bank Corporation to from UBS AG Oct 1998 – $680 million loss from deal with LTCM
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What went wrong?
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Goldstein's belief in autonomy was accepted and encouraged at the top. Risk monitoring at UBS was not independent. Lack of experienced personnel Politics within the organization
Learning from the disaster
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Independent and Efficient Risk Control Mechanisms Check and limit on trading activities Banks should not possess a large and relatively illiquid hedge fund investments in their Treasury Account
THE RISE AND FALL OF ?COPPER MAN?
SUMITOMO CORPORATION
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Year of Scam – 1996
Impact ( Total Loss) -$ 2.6 billion, largest unauthorized trading loss Derivative Instrument – Copper Futures Key Person – Yasuo Hamanaka
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About Sumitomo
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Sumitomo was initially established as ?Osaka Hokko Kaisha Limited? in December 1919 with a capital of 35 million yen The company entered into the trading business in 1945 with a new name ?Nihon Kensetsu Sangyo Kaisha Limited? In 1973, it got listed on the Frankfurt Stock exchange and in 1978 it adopted the name ?Sumitomo Corporation? Sumitomo consists of six corporate groups, nine business units and twentyeight business divisions The company has nine business divisions - Iron & Steel, Nonferrous Metals, Electric, Machinery, Produce & Fertilizer, Chemicals, Textile, General Products & Fuel and Real Estate
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Chronology of events
1985 ? Hamanaka started off-the-balance-sheet trading in 1985 with Saburo Shimizu, his former boss and then leader of Sumitomo's copper trading team, accumulating losses of 6.5 billion yen by the time Shimizu quit the firm in 1987 ? On taking charge of the copper trading team, Hamanaka tried to recover the losses by taking huge positions in copper commodity futures on the London Metal Exchange 1988 ? The huge volume of trading attracted the attention of the exchange and it gave a warning to Hamanaka. ? Hamanaka then struck a deal with Merrill Lynch for US $150 mn, which enabled him to trade via Merrill at LME
1990 ? Hamanaka borrowed money from several banks without any authorization from his seniors. ? He used the funds either to buy copper or pay for the collateral that he was required to deposit at the LME to cover loss-making positions ? Hamanaka was reporting huge trading profits to the top management by showing invoices of fictitious option trades, which he had created through a nexus with some brokers 1993-1994 ? Hamanaka forged the signatures of his superiors on four documents to keep his off-the-book trading from being discovered by Sumitomo and his clients
Chronology of events
1994 ? An unnamed Merrill managing director devised a plan whereby Sumitomo and Global Minerals & Metals Corp, New York opened an account in the name of Sumitomo, in which Global would have trading authority, but which was backed by Sumitomo's credit
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Hamanaka began to purchase "long" forward copper positions on the London Metal Exchange (betting that copper prices would rise), primarily through a Merrill account Together with Sumitomo's long positions at Merrill, and also at other brokers, Sumitomo and Global held 1.35 million metric tons of London Metal Exchange forward copper contracts Global and Sumitomo's warrant-taking operation was motivated by their intention to manipulate prices and spread, not by genuine commercial need, and they were attempting to manipulate, and were successfully manipulating the world's copper markets
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Copper price at LME
Chronology of events
December 1995 ? But laws of supply and demand cannot be manipulated for long. Regulators eventually started probing the case. ? After knowing that Mr. Hamanaka had manipulated the market into an artificially high zone, hedge funds and other short-sellers came into act and causing the Copper prices to fall on London Metal Exchange
June 13, 1996 ? Sumitomo Corp. discloses that it had lost $1.8 billion in copper trading on LME
Chronology of events
September 1996 ? Sumitomo disclosed the revised loss figure of $2.6 bn represented about 10% of Sumitomo's annual sales
October 1996 ? Japanese authorities arrest Mr. Hamanaka on charges he forged documents involving trades with Merrill Lynch and other metalstrading firms May 1998 ? Sumitomo consents to pay $125 million to settle case with Commodity Futures Trading Commission.
What went wrong??
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Debacle was the result of Sumitomo's poor managerial, financial and operational control systems. Due to this, Hamanaka was able to carry on unauthorized trading activities undetected by the top management The vesting of excessive decision power on a single employee and failure to implement the job rotation policy By entering into fictitious trades and manipulating accounts, Hamanaka successfully misled the management to believe that he was making huge profits
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Key Learning
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Do not vest excessive decision on a single employee Sound operational and monitoring system should be in place Successful Traders May Require More, Not Less, Scrutiny
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Metallgesellschaft Failed Hedge…
Metallgesellschaft
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Year of Scam – 1993
Impact ( Total Loss) – USD 1.96 Billion Derivative Instrument - Oil Futures
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Key Person - Heinz Schimmelbusch
About Metallgesellschaft
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one of Germany's largest industrial conglomerates based in Frankfurt Revenue - 10 billion US dollars
Employee – 20000 Engaged in wide range of activities, from mining and engineering to trade and financial services
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How did it happen?
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Around 1993, MG‘s trading subsidiary, MG Refining and Marketing (MGRM) offered several novel programs like - ?firm-fixed? program under which the customer would agree to a fixed monthly delivery of oil products at a set price -?firm-flexible? program which specified a fixed price and total volume of future deliveries but gave the customer some flexibility to set the delivery schedule In 1993, MG Refining and Marketing (MGRM), established very large energy derivatives (futures and swaps) positions to hedge its price exposure on its forward-supply contracts to deliver gasoline, diesel fuel and heating oil (about 160 million barrels) to its customers over a period of ten years at fixed prices.
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Most of the forward contracts were negotiated during the summer of 1993 when energy prices were low and falling and the contracts came with cash-out option if the energy price were to rise above the contractually fixed prices.
MGRM hedged this price risk with energy futures contracts of between one to three months to maturity at NYMEX and OTC swaps to protect the profit margins in its forward delivery contracts by insulating them from increases in energy prices. MGRM would gain substantially from its derivative positions if the energy prices rise. During the later part of 1993, however, energy prices fell sharply resulting in unrealized losses and margin calls on derivative positions in excess of $900 million.
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MGRM‘s hedging strategy included short-dated energy futures contracts and OTC swaps – a ?stack and roll? or ?rolling stack? strategy.
Under this strategy, MGRM opened a long position in futures staked in the near month contract. Each month MGRM would roll the stack over into the next near month contract, gradually decreasing the size of the position. Under this plan the total long position in the stack would always match the short position remaining due under the supply contracts. A stack hedge refers to a futures position being ?stacked? or concentrated in a particular delivery month (or months) rather than being spread over many delivery months. This exposed the firm to rollover risk.
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The stack and roll strategy can be profitable when markets are in ?backwardation,? that is, when spot prices are higher than futures prices.But when markets are in ?contango,? when futures prices are higher than spot prices, the strategy will result in losses.
MGRM failed to factor the rollover risk (that arises from the contango) into the price of the call options within forward fixed-rate contracts. This rollover loss was the real economic loss that MGRM suffered, i.e. they were unrecoverable. According to an MG spokesperson, hedge positions position was the equivalent of 85 days worth of the entire off output of Kuwait. If oil prices were to drop, MGRM would lose money on their hedge positions and would receive margin calls on their futures positions.
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Although gains in the forward contract positions would offset the hedge losses, a negative cash flow would occur in the short run because no cash would be received for the gain in the value of the forwar contracts until the oil was sold.
MGRM‘s strategy exposed it to three significant and related risks: rollover risk, funding risk, and credit risk, because of the maturity mismatch between the hedge and the delivery contracts and other features. It was exposed to rollover risk because of uncertainty about whether it would sustain gains or losses when rolling its derivatives position forward. It is exposed to funding risk because of the marked-to-market conventions that applied to its short-dated derivative‘s position.
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It is exposed to credit risk because of its forward delivery counter-parties might default on their long-dated obligations to purchase oil at fixed prices. When the oil price fell yet more precipitously at the end of the 1993, the company did not have sufficient cash to continue to roll over its stack of oil futures contracts as planned and could not meet a large number of its other obligations until it received an emergency line of credit from its bankers. Losses eventually totaled nearly $1.3 billion. By January 1994 the firm was close to declaring bankruptcy and its future was not clear.
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What went wrong?
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The average trading volume in the heating oil and unleaded gasoline pits usually averages anywhere from 15,000 to 30,000 contracts per day. With MGRM reportedly holding a 55,000 contract position in these contracts. The exchange market simply could not handle an effective hedge with a position so large and out of character. It created a funding risk for MGRM that proved enormous. Wrong assumptions of the architects of MGRM‘s hedging strategy made regarding the likely future behavior of basis in oil futures and forward markets (backwardation) No steps are taken by MGRM to reduce the variability of its cash flows
The deception
China Aviation Oil (CAO)
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Year – 2004 Country – China Amount lost – USD 0.55 billion Source of loss – Oil Options Person associated – Chen Juilin
About the company
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Incorporated in 1993
Dealt with the procurement of jet fuel for airports in China Had a 100% market share of the procurement of imported jet fuel for China's civil aviation industry Initially, started trading of swaps and futures Later, entered into speculative trading in fuel options
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Valuation of options
Option Fair Value = Intrinsic Value + Time Value
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The Intrinsic Value is the value of the option if it would expire today (e.g. for a call option it is Max(0,S-K)). The Time Value reflects the value of the volatility of the market
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Moneyness of options
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ATM: At-the-money
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An option is ATM if the strike price is the same as the current price of the underlying security No intrinsic value, only time value
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ITM: In-the-money
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Positive intrinsic value as well as time value. A call option is ITM when the strike price is below the current trading price. A put option is ITM when the strike price is above the current trading price.
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OTM: Out-of-the-money
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No intrinsic value. A call option is OTM when the strike price is above the current trading price A put option is OTM when the strike price is below the current trading price
What happened at CAO?
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Starting Q3 2003, CAO took a bearish view on oil markets
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Consistent with this view, CAO sold call options and purchased put options on Jet Fuel
These options were valued in their profit & loss accounts based on the Intrinsic Value only (i.e. not taking into account the Time Value) With the market moving against their position, CAO restructured their books at 3 different times by repurchasing the call options sold earlier and selling call options with a longer maturity. With oil prices continuing to rise, CAO could not satisfy the resulting cash (margin) calls from the call option buyers and had no choice but to go public with their results.
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Simplification of CAO‘s trading strategy
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Action 1: On 1st October 2003 the company sold 100 OTM call option with expiry 1st April 2004
Action 2: On 1st March 2004 the company repurchased the April 04 option and sold an OTM call option with expiry 1st July 2004 Action 3: On 1st June 2004 the company repurchased the July 04 option and sold an OTM call option with expiry 1st November 2004; Action 4: On 1st October 2004 the company repurchased the November 04 option and sold an OTM call option with expiry 1st January 2005.
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Simplification of CAO‘s trading strategy
Oil Futures prices and timing of CAO’s actions
Simplification of CAO‘s trading strategy
Estimated Income from the options strategy
(P&L X refers to CAO’s P&L)
What went wrong?
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The speculative option trading started without it being properly encapsulated in risk management policies and senior management oversight.
The option contracts were not valued on a best practice basis. In particular, time value was not considered. The company stuck to its valuation approach, despite the confirmations received from the counterparties that contained significantly different prices.
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The errors in the valuation of the open position, led to erroneous financial statements.
There were several roll-overs of loss generating positions, whereby options on bigger volumes were sold to generate sufficient cash to settle the losses on an existing position.
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Lessons learned
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Derivative mishaps are not due to inherent dangerous character of instruments, but due to ill-conceived and poorly defined strategies Hence, good Governance and Risk management systems are necessary for the businesses active in financial derivatives Well defined rules in financial management activities to create accountability
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Almost a text book example of what NOT to do in derivatives business …
Barings Bank
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A 233 year old institution, England‘s oldest merchant bank Year of Scam – 1995
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Impact ( Total Loss) -$1.4 billion
Derivative Instrument – Japan Index Futures Key Person – Nick Lesson Original strategy – Nikkei 225 arbitrage between SIMEX and OSE
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Chronology of Events
1992 Lesson becomes the head of settlements for Barings Future Singapore 1994 Lesson becomes head of trading floor too – derivative profit from $2 mn to $20 mn End of January 1995 From hedging to gambling January 17 1995 Kobe earthquake and Nikkei wobbles
January 20 ? Lesson buys 11,000 Nikkei contracts
January 17 – January 23 ? Piling up of Nikkei futures to keep Nikkei above 18500 to keep 40,000 outstanding options contract profitable
January 23 ? Tokyo stock market plunges 1000 points to under 17,800
January 23 – February 23 ? Lesson tries to run upstream and losses keep on mounting ? Dual role of Lesson and loose internal control helped him to disguise all losses under A/c : 88888
February 23 ? Outstanding index futures position reaches $7 bn
February 25 - 26 ? Attempts to raise enough private money before market opens on Monday
February 26 ? Barings Plc declared bankruptcy
Where lies the onus?
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The rogue trader :
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From index futures arbitrage to straddles Head of trading floor and the head of settlement – dissolving the Chinese wall
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Bank’s aristocratic management:
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No management control and internal control No clear segregation of duties Huge margin calls from SIMEX and OSE – did management actually understand the derivative business?
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The Exchanges – SIMEX and OSE
THANK YOU
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