Global Derivatives Debacles : From Theory to Malpractice

by Jacque, Laurent L.

• ISBN13: 9789812837707
• ISBN10: 9812837701
• Format: Hardcover
• Copyright: 2010-04-28
• Publisher: World Scientific Pub Co Inc

Summary

This book analyzes in depth all major derivatives debacles of the last half century including the multi-billion losses and/or bankruptcy of Metallgesellschaft (1994), Barings Bank (1995), Long Term Capital Management (1998), Amaranth (2006), Société Générale (2008) and AIG (2008). It unlocks the secrets of derivatives by telling the stories of institutions which played in the derivative market and lost big. For some of these unfortunate organizations it was daring but flawed financial engineering which brought them havoc. For others it was unbridled speculation perpetrated by rogue traders whose unchecked fraud brought their house down. Should derivatives be feared as financial weapons of mass destruction” or hailed as financial innovations which through efficient risk transfer are truly adding to the Wealth of Nations? By presenting a factual analysis of how the malpractice of derivatives played havoc with derivative end-user and dealer institutions, a case is made for vigilance not only to market and counter-party risk but also operational risk in their use for risk management and proprietary trading. Clear and recurring lessons across the different stories call not only for tighter but also smarter” control system of derivatives trading and should be of immediate interest to financial managers, bankers, traders, auditors and regulators who are directly or indirectly exposed to financial derivatives. The book groups cases by derivative category, starting with the simplest and building up to the most complex — namely, Forwards, Futures, Options and Swaps in that order, with applications in commodities, foreign exchange, stock indices and interest rates. Each chapter deals with one derivative debacle, providing a rigorous and comprehensive but non-technical elucidation of what happened.

Table of Contents

Preface	p. vii
Acknowledgments	p. ix
About the Author	p. xi
List of Figures	p. xix
List of Tables	p. xxiii
List of Boxes	p. xv
Derivatives and the Wealth of Nations	p. 1
What are Derivatives?	p. 2
A Brief History of Derivatives	p. 4
Derivatives and the Wealth of Nations	p. 8
Organization of the Book	p. 9
Bibliography	p. 11
Forwards	p. 13
Showa Shell Sekiyu K.K.	p. 15
Hedging Currency Risk at Oil Companies	p. 16
The Mechanics of Hedging Dollar Exchange Rate Risk and Oil Price Risk	p. 19
Was Showa Shell Hedging or Speculating?	p. 21
Concealing Currency Losses	p. 22
The Story Unfolds	p. 22
Forecasting Exchange Rates: Treacherous at Best	p. 23
The Moral of the Story	p. 25
Citibank's Forex Losses	p. 29
Currency Trading in the Tranquil Days of Bretton Woods	p. 30
Gambling on Currencies with Forward Contracts	p. 32
How Do Banks Keep a Lid on Their Foreign Exchange Trading Operations	p. 33
Speculating from a Commercial Bank's Trading Desk: When Citibank is Not Quite a Hedge Fund a La Georges Soros	p. 35
Hasty and Costly Conclusion	p. 38
The Moral of the Story	p. 39
Bank Negara Malaysia	p. 41
What is Central Banking All About?	p. 42
Bank Negara as a Macro-Hedge Fund	p. 43
How Did Bank Negara Speculate?	p. 44
Futures	p. 47
Amaranth Advisors LLC	p. 49
The Rise and Fall of Amaranth Advisors LLC	p. 50
Genesis of Natural Gas Derivatives	p. 52
A Primer on Speculating in Natural Gas Derivatives	p. 53
The Alchemy of Speculation Through Natural Gas Futures	p. 58
The Story Unfolds: Amaranth Speclative Assault on Nymex	p. 60
Risk Management at Amaranth	p. 68
The Moral of the Story	p. 70
Postscript	p. 71
Metallgesellschaft	p. 73
The Metallgesellschaft Debacle	p. 74
The "Long and Short" of Hedging in the Oil Market	p. 77
Numerical Illustration of "Ebbs & Flows" Under a "Stack & Roll" Hedge	p. 83
The "Message is in the Entrails": Empirics of the Oil Market (1983-2002)	p. 85
If Only MGRM Had Been Allowed to Roll the Dice	p. 89
When a Hedge is a Gamble: Was MGRM Hedging or Speculating?	p. 92
MGRM as a Market Maker	p. 93
The Moral of the Story	p. 94
Bibliography	p. 96
Sumitomo	p. 97
Was Sumitomo Manipulating Copper Prices?	p. 98
Alarm Bells	p. 100
Debacle	p. 101
Postscript	p. 101
Options	p. 103
Allied Lyons	p. 105
A New Mission for Allied Lyons Treasury Department	p. 106
A Primer on Currency Options: Was Allied Lyons Hedging or Speculating?	p. 109
Selling Volatility: Allied-Lyons "Deadly Game"	p. 115
Alarm Bells are Ignored as the Story Unfolds	p. 121
The Moral of the Story	p. 122
Appendix: Pricing Currency Options	p. 123
Allied Irish Banks	p. 125
Rusnak and Currency Trading at Allfirst	p. 125
Gambling on Currencies with Forward Contracts	p. 127
Arbitraging the Forward and Option Market: The International Put-Call Parity Theorem	p. 129
The Art of Concealment	p. 133
When Alarm Bells are Ignored	p. 137
The Moral of the Story	p. 139
Epilogue	p. 140
Bibliography	p. 140
Barings	p. 143
The Rise and Fall of the House of Barings	p. 144
Rogue Trader	p. 146
Arbitrage	p. 148
From Harmless Arbitrage to Lethal Speculation	p. 151
A Primer on How to Speculate with Options	p. 156
Financing Margin Calls by Selling Volatility	p. 161
Warning Bells	p. 168
The Art of Concealment	p. 169
The Moral of the Story: Leeson's Seven Lessons	p. 174
Epilogue	p. 177
Bibliography	p. 177
Société Générale	p. 179
The Making of a Rogue Trader	p. 179
From Arbitrage to Directional Trades	p. 182
Hasty Conclusion	p. 188
When Alarm Bells are Ignored	p. 190
The Art of Concealment	p. 192
The Moral of the Story	p. 192
Postscript	p. 195
Bibliography	p. 196
Swaps	p. 197
Procter & Gamble	p. 199
How to Reduce Financing Costs with Levered Interest Rate Swaps	p. 200
Embedded Options and Hidden Risks	p. 206
Landmark Lawsuit	p. 210
The Moral of the Story	p. 213
Bibliography	p. 214
Gibson Greeting Cards	p. 217
Orange County	p. 221
Municipal Finance in Orange County	p. 222
A Primer on Fixed Income Securities	p. 224
Anatomy of Orange County Asset Portfolio	p. 227
OCIP as a Hedge Fund	p. 232
Double Jeopardy: How Orange County Collapsed	p. 236
Was Filing for Bankruptcy Warranted?	p. 237
The Moral of the Story	p. 239
Epilogue	p. 242
Bibliography	p. 244
Long-Term Capital Management	p. 245
What are Hedge Funds?	p. 246
The Rise of Long-Term Capital Management	p. 247
The Alchemy of Finance	p. 249
Relative Value or Convergence Trades	p. 252
The Central Bank of Volatility	p. 257
Straying Away from the Master Plan	p. 263
The Fall of LTCM	p. 264
The Rescue of LTCM	p. 267
The Moral of the Story	p. 270
Epilogue	p. 272
Bibliography	p. 273
AIG	p. 275
Securitization and Credit Default Swaps	p. 275
What are Credit Default Swaps (CDS)?	p. 277
The Moral of the Story	p. 279
From Theory to Malpractice: Lessons Learned	p. 281
Some First Principles	p. 281
Policy Recommendations for Non-financial Firms	p. 282
Policy Recommendations for Financial Institutions	p. 286
Policy Recommendations for Investors	p. 292
Policy Recommendations for Regulators	p. 293
Index	p. 297
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