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
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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