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