Derivatives Debacles

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Derivatives Debacles Case Studies of Large Losses
in Derivatives Markets
Anatoli Kuprianov
??? ??? R91723079 ??? ??? R92723028
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Outline

• Risk in Derivatives Markets
• CASE 1 MG case
• CASE 2 Barings case
• Conclusion Comments
• Other Reference

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???????????????????
? ?
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????
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1993.3
????????

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1.5???
1993.12
???????????
15???
?????? Metallgesellschaft
1994.4
??????(PG)
????
1.6???
1994.12
??????
16.9???
?????? ?????????
1995.2
??????
??225????????
14.7???
1995.9
??????
????
11???
LTCM
25???
1998.9
???????? ????????
?????????????????????
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Risk in Derivatives Markets

• Four basic kinds of risks
• Market Risk ( Price Risks)
• Operational Risk
• Counterparty Credit Risk
• Legal Risk

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CASE 1 MG case
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CASE 1 MG case

• Metallgesellschaft Refining and Marketing(MGRM)
• ????????Metallgesellschaft AG??????
• ???????????????????????
• ???????????????,??????
• ????CFO -W. Arthur Benson
• ????Futures -front-month contract on NYMEX
• Swaps -receive floating and pay fixed price
• ???????1.3 billion

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CASE 1 MG case

• MGRMs Marketing Program
• Firm-Fixed Firm-Flexible Programs
• MGRM supplies a fixed monthly deliveries of oil,
  gasoline, and heating
• oil at a fixed price to contracted customers.
• In Common
• Cash-out provisions ( options for early
  termination )
• The Main Difference in Cash-out provisions
• The firm-fixed contract
• ( Current nearby futures price-the contract
  delivery price) 50
• The firm-flexible contract
• ( Second-nearest futures price-the contract
  delivery price) 100
• Other Difference
• A customer could request 20 of its
  contracted volume for any one year
• with 45 days notice. (Firm-Flexible)

if oil price of futures market rises above the
contract price
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CASE 1 MG case

• Illustration of the supply contract and the
  cash-out option

retailer faces a liquidity crisis
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CASE 1 MG case

• The cash-out proportion is 50
• the retailer gets 120,000 10 .5 600,000
• This allows the retailer to obtain cash in a
  liquidity crunch.

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CASE 1 MG case

• MGRMs contract price reflected a premium of 3
  to 5 per barrel.

Hedging Strategy
Oil prices
the firm could suffer massive losses.
stack-and-roll hedge buy a combination of
short-dated oil futures contracts and swaps.
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CASE 1 MG case

• Contango vs Backwardation Market
• Forward Price Spot price Cost of
  Carry-Convenience yield
• If Cost of CarrygtConvenience yield
• If Cost of CarryltConvenience yield
• A stack-and-roll strategy appeared to offer a
  means of avoiding such carrying costs because
  short-dated futures markets for oil products
  historically have tended to exhibit
  backwardation.

Contago MarketF gtS
Backwardation MarketFltS
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CASE 1 MG case
Basis Risk

• Illustration of the hedge strategy when the
  market is in backwardation

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CASE 1 MG case
Basis Risk

• Illustration of the hedge strategy when the
  market is in contago

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CASE 1 MG case
The process of huge losses in derivatives market
What happened if oil prices fall? (in late 1993)
Cause funding problems for MGRM
Cancel its long-term contracts with its customers
Terminate its hedging program
Cause about 1.3 billion loss
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CASE 1 MG case

• Critiques of MGRMs Hedging Program
• Edwards Canter and Mello Parsons
• Assume that the likely future behavior of basis
  in oil futures and forward markets is
  backwardation.

The permanent changes in the behavior of basis
are possible or not ?
Edwards Canter said Yes
Huge losses
Mello and Parsons are more critical of MGRMs
hedging program. They thought that it was
speculative in its design and intent.
2. MGRMs was overhedged.
Short-term oil futures prices tend to be more
volatile than prices on long-term forward
contracts.
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CASE 1 MG case

• Defense of MGRMs Hedging Program
• Culp Miller and Culp Hanke
• The hedger bears no carrying costs as long as the
  market exhibits backwardation.
• Culp Millers analysis shows that changes in
  basis affect only the portion of carrying cost
  borne by the hedger.
• Culp Miller argue that any long run expected
  losses due to basis risk were minimal considering
  historical patterns of backwardation in energy
  market.

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CASE 1 MG case

• Defense of MGRMs Hedging Program
• Culp Miller and Culp Hanke
• 2. Underestimated the value of MGRMs contracts
  with its customers.

Take proper account of unrealized gains in the
value of contracts
1.3 billion
170 million
Most of MGs reported losses were due to the
termination of its subsidiarys marketing program.
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CASE 1 MG case

• Defense of MGRMs Hedging Program
• Culp Miller and Culp Hanke
• 3. The firm should continue the hedging program.

Consider losses from MGRMs hedging program to
be sunk costs.
Culp Miller find out the program had a positive
expected net present value at the end of 1993.
The firm could have bought options to remain
hedged while it sought solutions to its
longer-term funding problems.
The Deutsche Bank was not only a creditor to MG
but also one of its largest shareholders,
therefore it should have been willing to continue
financing MGRMs hedge program.
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CASE 1 MG case
Response of the CFTC
MGRM
MG Futures, Inc.

material inadequacies in internal control systems
associated with MGRMs activity in energy and
futures markets
material inadequacies in internal control systems
associated with MGRMs activity in energy and
futures markets
Selling illegal, off-exchange futures contracts
Failing inform the CFTC of these material
inadequacies

• The CFTCs action rendered MGRMs firm-fixed
  agreements illegal and void.

• The CFTCs action would have created legal risk
  for MG.

• Miller and Culp criticized that CFTCs action
  created uncertainty about the legal status of
  commercial forward contracts.

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CASE 1 MG case

• An Overview of Policy Concerns
• MGRMs huge losses are attributable more to
  operational risk than to market risk.
• There is no need for new government policies or
  more comprehensive regulation of derivatives
  markets.
• Systematic attempts to discourage such
  arrangement like the long-term, fixed-price
  delivery contracts would seem to be poor public
  policy.

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CASE 2 Barings case
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• Barings Bank (oldest merchant bank in Great
  Britain)
• Background19941995 ,around Kobe earthquake
• Character Nick Leeson -Wonder boy,
• 
  Turbo arbitrageur
  
• Operations
• Nikkei 225 Futures between
  OSE SIMEX
• JGB (Japanese Government
  Bond)
• Nikkei 225 Futures Call
  Put Options
• Result Loss ?927 million ,Barrings
  bankrupted

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CASE 2 Barings case

• Who is Nick Leeson?
• Operations in Morgan Stanley and Barings
• Accomplishment in Jakarta Branch
• Manager of BSS (Barings Securities Singapore)
• Take necessary exam in back office
• Transacting futures and options orders for
  clients
• Arbitraging Nikkei futures price between SIMEX
  and OSE

General manager, head trader, head of back
office, affluent experience
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Unauthorized Trading Activities
Arbitrage in Nikkei-225 futures and 10-yr JGB
Short Straddle Strategy - sale of Nikkei-225
futures options
Long position on Nikkei stock futures
1995.1.17 Kobe earthquake,1.23 Nikkei slumped
1500 pts
Long Nikkei-225 futures,attempt to pull up the
index
Nikkei fell again ? enormous margin calls (742 mn)
Everything is out of control!!
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The most expensive Im sorry!
My sincere apologies for the predicament I have
left you in. It was neither my intention nor aim
for this to happen.
Total loss 927 million (Barings Equity
440mn) ING buy 1 Recapitalize 660
million
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CASE 2 Barings case

• Criticism Over confident Leeson
• Huge position of market open interest
• Nikkei futures options values are 10 times of the
  banks capital size
• 61000 Nikkei futures contracts, 49 of Mar , 24
  of Jun of 1995
• Short 26000 JGB futures, 88 of Jun 1995
• Short Euroyen futures, 5 of June, 1 of both
  Sep and Dec 1995
• Special account -- 88888

Year 1992 1993 1994 1994 acc.
Loss(mn) 2 21 185 208
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CASE 2 Barings case

• Criticism Baringss management
• Support additional funding without inquiry
• Didnt prompt immediate inquiry to Leesons
  activities.
• Tony Hawes started investigating on Feb 6.
• Assurance to SIMEX on the belief of Leesons
  Hedging Strategy.
• Improper system and inadequate internal control
• No supervisory mechanism for BSS.
• Lack of segregation of front and back office.
• Lack of funding management institution.
• Lack of market risk and operational risk
  management.

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CASE 2 Barings case

• Criticism SIMEX
• System of clearinghouse
• SIMEX doubled the margin calls on Nikkei stock
  index futures.
• BFS (Barings Futures Singapore) the largest
  clearing member.
• Inexperienced dealing with insolvency of clearing
  member.
• SIMEX didnt have the detail information on
  individual account.
• Leeson provided false information of Baringss
  account.
• Insufficient communication between exchanges
• Disclosure of unusual large position.
• Confirm the position of hedging dealers.

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CASE 2 Barings case

• Policy concerns highlighted by Baringss default
• Windsor Declaration (May 1995, Windsor England)
• Calling to prompt National provisions and market
  procedures that facilitate the transfer of funds
  from failing members.
• Enhance emergency procedures.
• Improving the existing mechanism for
  international co-operation and communication
  among market authorities and regulators.
• International Organization of Securities
  Commissions
• Endorsed the Windsor Declaration.
• Ask members promoting measures in cross-border
  transactions.

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CASE 2 Barings case

• Policy concerns highlighted by Baringss default
• Futures Industry Association (FIA)
• Organized measures to improve the integrity of
  futures and options exchanges.
• Published 60 recommendations from risk management
  to customer protection.
• Encouraged nations to modified their laws when
  facing bankruptcy.
• Galvanize international efforts jointed by
  government officials and market participants.
• Reevaluate risk management, failing of
  clearinghouse.

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CASE 2 Barings case

• Lessons from the Barings debacle
• Careless about the warning signs
• Lack of segregation of duties between front and
  back offices.
• High level of funding requested by Leeson.
• Unreconciled balance of funds transfer to BFS to
  meet margin calls.
• High profitability is relative to high level of
  risk.
• The discovery of discrepancies in account by
  outside auditors.
• Communications from SIMEX.
• Market rumors and concerns.
• On-site examination of Leesons account came too
  late.
• Management teams have duties to fully understand
  the plans.

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CASE 2 Barings case

• Lessons from the Barings debacle
• Criticisms for the Bank of Englands supervision
• 25 percent of the organizations capital to the
  risk or loss.
• Increasing understanding of the non-banking
  business.
• Explicit internal guidelines .
• Closer work to the Securities and Futures
  Authority is needed.
• Falling at Barings were not a consequence of the
  complexities of the business.
• Legitimate concerns for policymakers
• Lack of communication between securities and
  futures.
• Conflicting laws on the legal status in the event
  of insolvency.

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Conclusion Comments

1. Firms management should understand fully and
   well monitor the activities of their
   subsidiaries.
2. Derivatives are not devil. Derivatives-related
   losses doesnt mean more regulations of
   derivatives markets needed.
3. Operational strategies, not only derivatives, can
   lead to loss money.
4. Attempts at stringent regulation can sometimes
   have undesirable side effects.

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Conclusion Comments

1. Market discipline is also a powerful form of
   regulation.
2. Derivatives enlarged the market size and
   stimulate the competition and innovation of
   financial markets.
3. Derivatives provided diverse solutions to funding
   policies, such as hedging, speculation and fund
   gathering.

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Lessons Short Straddle strategy
Short Call
Short Put
20000
18500

• 1999.1.5 Short 37925 Nikkei calls and 32967
  Nikkei puts
• Total contract volume 6.68 billion
• Barringss capital size 615 million

45
Sufficient funding support from Barrings group
46
Barrings groups merger in 1993
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CASE 1 MG case