RISK TAKERSUses and Abuses of Financial Derivatives

Second Edition

•s

John E. MarthinsenBabson College

PEARSON

PrenticeHall

Boston San Francisco New YorkLondon Toronto Sydney Tokyo Singapore Madrid

Mexico City Munich Paris Cape Town Hong Kong Montreal

Contents

Preface xv

PARTI

Chapter l Primer on Derivatives lIntroduction 1

What Are Derivatives? 3

Who Buys and Sells Derivatives? 4

Where Are Derivatives Bought and Sold? 4

Two Major Types of Derivatives 5Terminology That Is Common To All Derivatives 5Forward Contracts 5Options 9

Risk Notepad 1.1: OTC-Traded Versus Exchange-TradedDerivatives 13

Conclusion 16

Review Questions 16

Bibliography 18

PART II

Chapter 2 Employee Stock Options: WhatEvery MBA Should Know 19

Introduction 19

Employee Stock Options: A Major Pillar of ExecutiveCompensation 21

Why Do Companies Use Employee Stock Options? 22Aligning Incentives 22Hiring and Retention 23

Contents

Adjusting Compensation to Employee Risk Tolerance Levels 24Employee Tax Optimization 24Cash Flow Optimization for Companies 25

Option Valuation Differences and Human ResourceManagement 26

Risk No t epad 2 . 1 : What Effect Do Employee Stock Options Have onProfits? Should They Be Recorded as Expenses? 27

Problems with Employee Stock Options 43Employee Motivation 44The Share Price of "Good" Companies 45Motivating Undesired Behavior 45Improving Performance 46Absolute Versus Relative Performance 47

Some Innovative Solutions to Employee StockOption Problems 47Premium-Priced Stock Options 47Index Options 48Restricted Shares 51Omnibus Plans 51

Conclusion 52

Review Questions 52

Further Reading 54

Bibliography 54

Chapter 3 Roche Holding: The Company,Its Financial Strategy,and Bull Spread Warrants 59

Introduction 59

Roche Holding AG: Transition from a Lender to a Borrower 61Loss of the Valium Patent in the United States 61Rapid Increase in R&D Costs, Market Growth, and IndustryConsolidation 61Roche's Unique Capital Structure 62Roche Brings in a New Leader and Replaces Its ManagementCommittee 64A New Financial Strategy 64

Contents '

Roche's 1991 Bull Spread Issue 67Why Did Roche Choose Long-Term, Dollar-Denominated Debt? 67Details of the Bull Spread Issue 68Target Investor Group 68

Risk Notepad 3 .1 : What Are the Differences Between Options andWarrants? 69Analysis of the Bull Spread's Return to Investors 70Analyzing the Bull Spread Issue from Roche's Side 80

Risk N o t e p a d 3.2: Calculation of the Weighted AverageReturn on Roche's Bond Cum Warrants 80Roche's Bull Spread Issue: The Result 86

Conclusion 87

Review Questions 89

Further Reading 91

Bibliography 91

PART III

Chapter 4 Metallgesellschaft AG: Illusionof Profits and Losses, Realityof Cash Flows 92

Introduction 92

Metallgesellschaft: Evolution of the Companyand Its Product Lines 93

Energy Derivatives at MGRM 94Energy Markets on a Roller-Coaster Ride 94

Risk N o t e p a d 4 . 1 : What Is the Difference Between Contangoand Backwardation? . 96MGRM's Innovative Energy Derivative Products 98

Understanding How MGRM Hedged ItsForward Exposures 100Payoff Profile of Short Forward Positions 100The Ideal Hedge Was Not Available 101Stack-and-Roll Hedge 102How Effective Is a Stack-and-Roll Hedge? 104MGRM's Large Positions Create Problems 114MGRM Butts Heads with NYMEX and the CFTC 115

Contents

MGRM's Profitability: It's All in How You Account for It 116MGRM's Credit Rating 117

The Effects of an Itchy Trigger Finger 117

Was MGRM Hedging or Speculating? 118

Corporate Governance Issues 118

Conclusion 120

Epilogue: What Happened to the Key Players inthe MGRM/MGAG Disaster? 121

Review Questions 123

Further Reading 124

Bibliography 124

Chapter 5 Swaps That Shook an Industry:Procter & Gamble versusBankers Trust 126

Introduction 126

P&G's Motivation for the Swaps 128Motives for the U.S. Dollar-Denominated Interest RateSwap 129Motives for the German Mark-Denominated Interest Rate Swap 129Motives for Using the Over-the-Counter Market 130

The U.S. Dollar-Denominated Swap 131Plain Vanilla Swap 131P&G's Gamble: The Speculative Side-Bet 132

Risk N o t e p a d 5 . 1 : Security Yield versus Price 135Losses on P&G's U.S. Dollar Interest Rate Swap 140

German Mark-Denominated Interest Rate Swap 142

The Suit Against Banker's Trust 144

Risk Notepad 5.2: Value at Risk 146

The P&G-BT Settlement 147

How Did BT Fare After the Swaps? 147

P&G-BT from an Investor's Perspective 148

Contents ix

The Landmark P&G-BT Court Opinion 149Major Legal Issues 149An Unusual Court Opinion 150Summary of the Court Opinion 151

Disclosure Reform After P&G-BT 151

Should Corporate Treasuries Be Profit Centers? 1 52

Conclusions 153

Epilogue: What Happened to the Players in P&G-BT? 1 54

Review Questions 155

Further Reading 156

Bibliography 156

Chapter 6 Orange County: TheLargest Municipal Failurein U.S. History 158

Introduction 158

* Robert Citron and the Orange County Board of Supervisors 1 59

The Orange County Investment Pool 162

The Major Risks Facing Assets in the OCIP Portfolio 164Credit Risk 165Market Risk 165Liquidity Risk 166

OCIP's Assets and Funding Sources 166Structured Notes 167

Risk No tepad 6 . 1 : Other Assets in the OCIP Portfolio 168Fixed-Income Securities 170OCIP's Funding Sources 170

Leveraging the OCIP Portfolio 172

Effects of Leverage on OCIP's Return 175OCIP's Rising Returns: Effects of Falling Interest Rates 175OCIP's Return Stabilizes: 1993 177OCIP's Returns Plummet: 1994—Effects of Rising Interest Rates 177

The Consequences 179

Contents

Market Risk Causes Liquidity Risk 179Government Paralysis 180Citron Resigns 181Lack of Liquidity Leads to Bankruptcy 181Fire Sale of the OCIP Portfolio 181

Monday-Morning Quarterbacking 182Was Orange County Truly a Derivative-Related Failure? 182Was Orange County Really Bankrupt? 183Was It a Mistake to Liquidate the OCIP Portfolio? 184Could the Debacle Have Been Predicted? 186

Sentences, Blame, and Reform 186Robert Citron 187Other Players: Matthew Raabe and Merrill Lynch 188Stealth Supervision: Shared Blame 189Governance Reforms 189

Lessons Learned from Orange County 190Safety, Liquidity, and High Yield Are an Impossible Combination 190If You Can't Explain It, Then Don't Do It 190

Conclusion 191

Review Questions 192

Further Reading 193

Bibliography 193

Chapter 7 Barings Bank PLC: Leeson'sLessons 194

Introduction 194

Barings Bank PLC 195

Nick Leeson: From London to Jakarta to Singapore 196

What Was Leeson Supposed to Be Doing at BFS? 197

Five Eights Account 199

Risk Notepad 7 .1 : Error Accounts 200

Leeson's Trading Strategy: Doubling 202

Funding Margin Calls 203

Contents xi

Risk Notepad 7.2: Doubling 204Increasing Commission Income by Offering Deals atNon-Market Prices 205Using the Financial Resources of Barings as His Cash Cow 205Booking Fictitious Trades and Falsifying Records 207

Risk Notepad 7.3: Leeson's Most Flagrant Falsification Scheme 208

Net Profit/Loss Profile of Leeson's Exposures 209Leeson's Long Futures Positions 209Leeson's Short Straddles 210Profit/Loss Profile: Combining One Short Straddle and One LongFutures Contract 211Profit/Loss Profile: Combining a Long Futures Positionand "Numerous" Short Straddles 214Massive Purchases of Nikkei 225 Futures Contracts 215

Beyond Irony: The Barings Failure in a Broader Time Frame 216

A Bank for a Pound 217

Aftermath of the Barings Failure 218

How Could Barings Have Caught Leeson Sooner? 219

Conclusions: Leeson's Lessons 222

Epilogue: What Happened to the Key Players inthe Barings Financial Fiasco? 224

Review Questions 229

Bibliography 230

Chapter 8 Long-Term CapitalMismanagement: "JMand the Arb Boys" 231

Introduction 231

Risk Notepad 8 .1 : What Is a Hedge Fund? 232

LTCM: The Company 234The LTCM Business 234The Principals 234

LTCM's Strategy 236

Contents

Identifying Small Market Imperfections 237Using a Minimum of Equity Capital 237Securing Long-Term Funding 242Charging Hefty Fees 243

LTCM's Impressive Performance: 1994-1997 243

LTCM's Contributions to Efficient Markets 246

Why and How LTCM Failed 246Exogenous Macroeconomic Shocks: U.S. and GlobalSpreads Widen 247

Risk Notepad 8.2: What Is Contagion? 250Endogenous Shocks: Spreads Go Helter Skelter and VARGets Twisted 250Feedback Shocks 253

The Fed, Warren Buffett, and the Rescue of LTCM 256

Risk Notepad 8.3: Another Look at Warren Buffett'sOffer for LTCM 258

Conclusions and Lessons to Be Learned 260Be Careful What You Wish For 261Beware of Model Risk 261All for One and " 1 " for All 261Leverage Is a Fair-Weather Friend 262Financial Transparency Is the First Step in Meaningful Reform 262In the Long Run, Bet on Global FinancialMarkets Being Efficient 263You Can't Float Without Liquidity 263Some Things Are Worth Doing for the Greater Good 263

Epilogue: What Happened to the Principals, Creditors, Investors,and Consortium? 264The Principals and Employees^ 264Creditors and Investors 265The Consortium 266

Review Questions 266

Further Reading 267

Bibliography 267

Contents xiii

Chapter 9 Amaranth Advisors LLC: UsingNatural Gas Derivatives to Beton the Weather 270

Introduction 270

Amaranth Advisors LLC 271

Natural Gas Markets 273

Amaranth's Natural Gas Trading Strategy and Performance: 2005to 2006 2752005: Using Long Call Options to Bet on the Weather 2762006: Using Futures and Spreads to Bet on the Weather 277

Risk Notepad 9 .1 : Measuring Natural Gas and PuttingAmaranath's Positions into Perspective 280

Risk Notepad 9.2: Understanding How Profits Are Earnedon Spread Trades 281

What Caused Amaranth's Catastrophic Losses? 287Inadequate Risk Management Practices 287Lack of Liquidity 290Extraordinarily Large Movements in Market Prices 291

Explosion or Implosion? Who Got Hurt? 292

Aftermath 293Did the Futures Markets Function Effectively? 294Did Amaranth Dominate Futures Markets, Engage inExcessive Speculation, and/or Conduct RegulatoryArbitrage? 294Did Amaranth Manipulate Prices? 300

Risk Notepad 9.3: A Tale of Two Hedge Funds 302

Conclusion 308

Epilogue: What Happened to the Amaranth's Tradersand Managers? 309Brian Hunter: Chief Trader at Amaranth 309Nick Maounis: CEO and Founder of Amaranth 310Harry Arora: Trader and Former Head (and LaterCo-head) of Amaranth's Commodity Group;Brian Hunter's Former Boss 310Matthew Donohoe: Trader at Amaranth WhoWas Also Charged by FERC with Price Manipulation 310

Contents

Assorted Other Things That Happened 311JPMorgan Chase & Co.: Amaranth's ClearingAgent: Purchased Part of Amaranth's EnergyBook in September 2006 311Citadel: Hedge Fund That Purchased Partof Amaranth's Energy Book in September 2006 311Paloma Partners Management Company: Hedge FundThat Nick Maounis Left Before Starting Amaranthand Which Provided Much of Amaranth's Initial Funding 311

Review Questions 311

Further Reading 312

Bibliography 313

Glossary 315

Index 321