Risk Takers

John E. Marthinsen, Babson College, MA

• Chapter 1: Primer on Derivatives  1 What Are Derivatives?  1 Who Buys and Sells Derivatives?  2 Where Are Derivative Contracts Bought and Sold?  2 Two Major Types of Derivatives  3 Forward Contracts  3 Option Contracts  4 Forward Contracts  4 Long Forward in Action  5 Short Forward in Action  6 Options  7 Call Options  7 Put Options  8 American versus European Options  9 Examples of Puts and Calls in Action  9 4,000 Years of Derivatives  13 Conclusion  14 Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives  15 Review Questions  18 Bibliography  19 Chapter 2: Employee Stock OptionsA User’s Guide  21 ESOs: A Major Pillar of Executive Compensation  21 Why Do Companies Use ESOs?  22 Aligning Incentives  22 Hiring and Retention  23 Adjusting Compensation to Employee Risk Tolerance Levels  24 Employee Tax Optimization  24 Cash Flow Optimization  25 Option Valuation Differences and Human Resource Management  26 Problems with ESOs  37 Employee Motivation  38 Improving Performance  40 Absolute Versus Relative Performance  40 Possible Solutions to Employee Stock Option Problems  41 Premium-Priced Stock Options  41 Index Options  42 Restricted Shares  45 Omnibus Plans  45 Conclusion  46 Review Questions  46 Bibliography  47 Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows  51 Metallgesellschaft: Evolution of the Company and Its Product Lines  51 Energy Derivatives at MGRM  52 Energy Markets on a Roller Coaster  53 Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation?  55 MGRM’S Innovative Energy Derivative Products  56 MGRM’s Embedded Options  58 Hedging MGRM’s Forward Energy Exposures  59 Payoff Profile of a Short Forward Position  59 The Ideal Hedge Was Not Available  61 Physical Storage Hedge  61 Stack-and-Roll Hedge  62 Cash Flow Effects of a Stack-and-Roll Hedge  64 Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months  65 Stack-and-Roll Hedge Ratios  69 MG Calls It Quits  69 MGRM Butts Heads with NYMEX and the CFTC  70 MGRM’S Profitability: It’s All in How You Account for It  71 MGRM’S Credit Rating  72 The Effects of an Itchy Trigger Finger  72 Was MGRM Hedging or Speculating?  72 Corporate Governance Issues  73 Conclusion  74 Review Questions  75 Bibliography  76 Chapter 4: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust  77 P&G’s Motivation for the Swaps  78 Motives for the U.S. Dollar–Denominated Interest Rate Swap  79 Motives for the German Mark–Denominated Interest Rate Swap  80 Motives for Using the Over-the-Counter Market  80 The U.S. Dollar–Denominated Swap  81 Plain Vanilla Swap  82 P&G’s Gamble: The Speculative Side-Bet  83 Viewing P&G’s Speculative Side-Bet as a Short Call Option  84 Risk Notepad 4.1: Security Yield versus Price  86 The Effect of Rising U.S. Interest Rates  87 Losses on P&G’s U.S. Dollar Interest Rate Swap  91 German Mark-Denominated Interest Rate Swap  93 The Suit against Banker’s Trust  95 Risk Notepad 4.2: Value at Risk  97 The P&G-BT Settlement  98 How Did BT Fare After the Swaps?  98 P&G-BT from an Investor’s Perspective  99 The Landmark P&G-BT Court Opinion  100 Major Legal Issues  100 An Unusual Court Opinion  101 Summary of the Court Opinion  102 Disclosure Reform after P&G-BT  102 Should Corporate Treasuries Be Profit Centers?  103 Conclusion  103 Review Questions  104 Bibliography  105 Appendix 4.1: What Is an Interest Rate Swap?  107 Chapter 5: Orange CountyThe Largest Municipal Failure in U.S. History  109 Robert Citron and the Orange County Board of Supervisors  109 The Orange County Investment Pool  112 The Major Risks Facing Assets in the OCIP Portfolio  114 Credit Risk  115 Market Risk  115 Liquidity Risk  116 OCIP’s Assets and Funding Sources  117 Structured Notes  118 Risk Notepad 5.1: Other Assets in the OCIP Portfolio  118 Fixed-Income Securities  120 OCIP’s Funding Sources  120 Leveraging the OCIP Portfolio  123 Effects of Leverage on OCIP’s Return  124 OCIP’s Rising Returns: Effects of Falling Interest Rates  124 OCIP’s Return Stabilizes: 1993  126 OCIP’s Returns Plummet: 1994?Effects of Rising Interest Rates  127 The Consequences  128 Market Risk Causes Liquidity Risk  129 Government Paralysis  130 Citron Resigns  130 Lack of Liquidity Leads to Bankruptcy  130 Fire Sale of the OCIP Portfolio  131 Monday-Morning Quarterbacking  131 Was Orange County Truly a Derivative-Related Failure?  131 Was Orange County Really Bankrupt?  133 Was It a Mistake to Liquidate the OCIP Portfolio?  134 Could the Debacle Have Been Predicted?  135 Sentences, Blame, and Reform  136 Robert Citron  136 Other Players: Matthew Raabe and Merrill Lynch  137 Stealth Supervision: Shared Blame  138 Governance Reforms  139 Lessons Learned from Orange County  139 Safety, Liquidity, and High Yield Are an Impossible Combination  139 If You Can’t Explain It, Then Don’t Do It  140 Conclusion  141 Review Questions  141 Bibliography  142 Chapter 6: Barings Bank PLCLeeson’s Lessons  143 Barings Bank PLC  143 Nick Leeson: From London to Jakarta to Singapore  144 What Was Leeson Supposed to Be Doing at BFS?  145 Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts?  147 Five Eights Account  148 Risk Notepad 6.2: Errors Accounts  149 Leeson’s Trading Strategy: Doubling  150 Risk Notepad 6.3: Doubling  152 Funding Margin Calls  153 Funding Source #1: Increasing Commission Income by Offering Deals at Non-Market Prices  153 Funding Source #2: Using the Financial Resources of Barings as His Cash Cow  154 Funding Source #3: Booking Fictitious Trades and Falsifying Records  155 Funding Source #4: Selling Options  156 Risk Notepad 6.4: Leeson’s Most Flagrant Falsification Scheme  156 Net Profit/Loss Profile of Leeson’s Exposures  157 Leeson’s Long Futures Positions  157 Leeson’s Short Straddles  159 Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract  161 Profit/Loss Profile: Combining a Long Futures Position and "Numerous" Short Straddles  162 Massive Purchases of Nikkei 225 Futures Contracts  163 Beyond Irony: The Barings Failure in a Broader Time Frame  164 A Bank for a Pound  165 Aftermath of the Barings Failure  167 How Could Barings Have Caught Leeson Sooner?  168 Conclusions  171 Review Questions  172 Bibliography  173 Chapter 7: Long-Term Capital Mismanagement"JM and the Arb Boys"  175 Risk Notepad 7.1: What Is a Hedge Fund?  176 LTCM: The Company  177 The LTCM Business  177 The Principals  177 LTCM’S Strategy  179 Identifying Small Market Imperfections  179 Using a Minimum of Equity Capital  180 Securing Long-Term Funding  184 Charging Hefty Fees  186 LTCM’S Impressive Performance: 1994–1997  186 LTCM’S Contributions to Efficient Markets  189 Why and How LTCM Failed  190 Catalyst #1: Exogenous Macroeconomic Shocks  190 Risk Notepad 7.2: What Is Contagion?  192 Catalyst #2: Endogenous Shocks  193 The Fed, Warren Buffett, and the Rescue of LTCM  198 Risk Notepad 7.3: Another Look at Warren Buffett’s Offer for LTCM  200 Conclusions and Lessons  202 Be Careful What You Wish For  203 Beware of Model Risk  203 All for One and "1" for All  203 Leverage Is a Fair-Weather Friend  204 Financial Transparency Is the First Step in Meaningful Reform  204 In the Long Run, Bet on Global Financial Market Efficiency  205 You Can’t Float Without Liquidity  205 Some Things Are Worth Doing for the Greater Good — 205 Epilogue  206 What Happened to the Principals, Creditors, Investors, and Consortium?  206 The Principals and Employees  206 Creditors and Investors  207 The Consortium  207 Review Questions  208 Bibliography  208 Appendix 7.1: Primer on LTCM’s Major Trades and Financial Instruments  210 Appendix 7.2: UBS and the LTCM Warrant Deal  213 Chapter 8: Amaranth Advisors LLCUsing Natural Gas Derivatives to Bet on the Weather  217 Amaranth Advisors LLC  217 Natural Gas Markets  219 Amaranth’s Natural Gas Trading Strategy and Performance: 2005–2006  222 2005: Using Long Calls to Bet on the Weather  222 2006: Using Futures and Spreads to Bet on the Weather  223 Risk Notepad 8.1: Measuring Natural Gas and Putting Amaranth’s Positions into Perspective  227 Risk Notepad 8.2: Primer on Spread Trades  228 What Caused Amaranth’s Catastrophic Losses?  234 Inadequate Risk Management Practices  234 Lack of Liquidity  236 Extraordinarily Large Movements in Market Prices  238 Explosion or Implosion? Who Got Hurt?  238 Questions Remaining After Amaranth’s Fall  240 Did the Futures Markets Function Effectively?  240 Did Amaranth Dominate the Natural Gas Futures Markets?  240 Did Amaranth Engage in Excessive Speculation?  243 Did Amaranth Commit Regulatory Arbitrage?  244 Did Amaranth Manipulate the Price of Natural Gas?  245 Risk Notepad 8.3: A Tale of Two Hedge Funds  248 Conclusion  254 Review Questions  255 Bibliography  256 Chapter 9: Société Générale and Rogue Trader Jérôme Kerviel  259 Société Générale (SocGen)  259 Jérôme Kerviel (JK)  259 Back, Middle, and Front Office Jobs at SocGen  260 Arbitraging Turbo Warrants  261 What Are Plain Calls and Puts?  261 What Are Turbo Warrants?  262 How JK Built His Mountainous Positions  265 2005  265 2006  266 2007  267 2008  269 JK’s Fraudulent Methods  269 Gaining Unauthorized Access to SocGen’s Computer Systems  270 Using Contract Cancellations and Modifications to Mask Positions and Risks  270 Entering Pairs of Offsetting Trades at Artificial Prices  271 Posting Intra-monthly "Provisions"  271 Navigating SocGen’s Dysfunctional Risk Management System  271 Exploiting Supervisor Turnover  273 How JK Was Caught  274 Paying the Piper  275 Did SocGen Know about JK’s Fictitious Trades?  276 Network Incentives: Why Did JK Go Undetected for So Long?  278 SocGen’s Bonus Incentives  279 Doubling Strategies, Prospect Theory, and Survival Theory  280 Prospect and Survival Theory  281 SocGen’s Risk Management Reforms  282 Conclusion  283 Review Questions  284 Bibliography  284 Chapter 10: AIG: Two Roads to Ruin AIG: The Company  288 AIG-INV  289 AIGFP  289 Securitization: MBS, ABS, CDOs, and MBOs  290 AIGFP’s Credit Derivative Portfolios  292 Major Keys to AIGFP’s Initial Success  294 AIG’s Chief Regulators  294 What Went Wrong?  295 AIG’s Credit Protection Exposures  296 The Sources of AIGFP’s Liquidity Problems  298 Securities Lending at AIG  301 AIG’s Risky Securities Lending Operations  304 AIG’s Bailout  306 What If AIG Was Allowed to Fail?  310 Regulatory Capital Risks  310 AIG’s Insurance Affiliates’ Risks  311 Contagion Risks  311 Criticisms of the AIG Bailout  312 Postscript  313 Conclusion  314 Review Questions  316 Bibliography  316 Appendix 10.1: Primer on Credit Derivatives  318 Risk Notepad 10.1.1: The Long and Short of Credit Derivative Lingo  318 Chapter 11: JPMorgan Chase and the "London Whale"  323 JPMorgan & Company, the CIO, and the SCP  324 JPM and JPM Bank  324 The CIO  325 The SCP  326 The SCP Time Line  327 Risk Notepad 11.1: What Are Risk-Weighted Assets?  329 Risk Notepad 11.2: What Are the Basel Accords?  330 What Went Wrong at the SCP?  330 Mistake #1: Ignoring the SCP’s Strategic Purpose  331 Mistake #2: A Failed Trading Strategy  332 Mistake #3: Disregarding JPM Bank’s Internal and External Risk Measures  336 Risk Notepad 11.3: The SCP’s Five Major Risk Measures  337 Risk Notepad 11.4: Basel II.5 Accord’s Four New Risk Measures  338 Mistake #4: Manipulating JPM Bank’s Risk Metrics  339 Mistake #5: Publicly Misrepresenting the SCP’s Financial Condition  341 Risk Notepad 11.5: What Is the Volcker Rule?  341 Dysfunctional Regulation  342 Conclusion  343 Aftermath  344 Risk Notepad 11.6: Aftermath  345 Review Questions  346 Bibliography  346 Appendix 11.1: Alphabetical List of the Main "London Whale" Decision Makers and Players  347 Appendix 11.2: Markit Group Limited  348 Risk Notepad A 11.2.1: A Rosetta Stone for Understanding Markit Group’s Credit Indices and Abbreviations  348 Index  351

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