GLOBAL DERIVATIVE DEBACLES

From Theory to Malpractice

CONTENTS

Preface

vii

Acknowledgments About the Author List of Figures List of Tables List of Boxes Chapter 1: Derivatives and the Wealth of Nations What are Derivatives? A Brief History of Derivatives Derivatives and the Wealth of Nations Organization of the Book Bibliography PART I: FORWARDS Chapter 2: Showa Shell Sekiyu K.K. Hedging Currency Risk at Oil Companies The Mechanics of Hedging Dollar Exchange Rate Risk and Oil Price Risk Was Showa Shell Hedging or Speculating?

ix xi xix xxiii xv 1 2 4 8 9 11 13 15 16 19 21

xiv Concealing Currency Losses The Story Unfolds Forecasting Exchange Rates: Treacherous at Best The Moral of the Story Chapter 3: Citibank's Forex Losses

Global Derivative Debacles 22 22 23 25 29 30 32 33

Currency Trading in the Tranquil Days of Bretton Woods Gambling on Currencies with Forward Contracts How Do Banks Keep a Lid on Their Foreign Exchange Trading Operations Speculating from a Commercial Bank's Trading Desk: When Citibank is Not Quite a Hedge Fund a La Georges Soros Hasty and Costly Conclusion The Moral of the Story Chapter 4: Bank Negara Malaysia What is Central Banking All About? Bank Negara as a Macro-Hedge Fund How Did Bank Negara Speculate? PART II: FUTURES Chapter 5: Amaranth Advisors LLC The Rise and Fall of Amaranth Advisors LLC Genesis of Natural Gas Derivatives A Primer on Speculating in Natural Gas Derivatives The Alchemy of Speculation Through Natural Gas Futures The Story Unfolds: Amaranth Speclative Assault on Nymex Risk Management at Amaranth The Moral of the Story Postscript

35 38 39 41 42 43 44 47 49 50 52 53 58 60 68 70 71

Contents Chapter 6: Metallgesellschaft The Metallgesellschaft Debacle The "Long and Short" of Hedging in the Oil Market Numerical Illustration of "Ebbs & Hows" Under a "Stack & Roll" Hedge The "Message is in the Entrails": Empirics of the Oil Market (1983-2002) If Only MGRM Had Been Allowed to Roll the Dice When a Hedge is a Gamble: Was MGRM Hedging or Speculating? MGRM as a Market Maker The Moral of the Story Bibliography Chapter 7: Sumitomo Was Sumitomo Manipulating Copper Prices? Alarm Bells Debacle Postscript PART III: OPTIONS Chapter 8: Allied Lyons A New Mission for Allied Lyons Treasury Department A Primer on Currency Options: Was Allied Lyons Hedging or Speculating? Selling Volatility: Allied-Lyons "Deadly Game" Alarm Bells are Ignored as the Story Unfolds The Moral of the Story Appendix: Pricing Currency Options Chapter 9: Allied Irish Banks Rusnak and Currency Trading at Allfirst Gambling on Currencies with Forward Contracts Arbitraging the Forward and Option Market: The International Put-Call Parity Theorem '

xv 73 74 77 83 85 89 92 93 94 96 97 98 100 101 101 103 105 106 109 115 121 122 123 125 125 127 129

xvi The Art of Concealment When Alarm Bells are Ignored The Moral of the Story Epilogue Bibliography Chapter 10: Barings The Rise and Fall of the House of Barings Rogue Trader Arbitrage From Harmless Arbitrage to Lethal Speculation A Primer on How to Speculate with Options Financing Margin Calls by Selling Volatility Warning Bells The Art of Concealment The Moral of the Story: Leeson's Seven Lessons Epilogue Bibliography Chapter 11: Societe Generate The Making of a Rogue Trader From Arbitrage to Directional Trades Hasty Conclustion When Alarm Bells are Ignored The Art of Concealment The Moral of the Story Postscript Bibliography

Global Derivatiye Debacles 133 137 139 140 140 143 144 146 148 151 156 161 168 169 174 177 177 179 179 182 188 190 192 192 195 196

Contents

xvii

PART IV: SWAPS Chapter 12: Procter & Gamble How to Reduce Financing Costs with Levered Interest Rate Swaps Embedded Options and Hidden Risks Landmark Lawsuit The Moral of the Story Bibliography Chapter 13: Gibson Greeting Cards Chapter 14: Orange County \

197 199 200 206 210 213 214 217 221 222 224 227 232 236 237 239 242 244 245 246 247 249 252 257 263 264 267 270

Municipal Finance in Orange County A Primer on Fixed Income Securities Anatomy of Orange County Asset Portfolio OCIP as a Hedge Fund Double Jeopardy: How Orange County Collapsed Was Filing for Bankruptcy Warranted? The Moral of the Story Epilogue Bibliography Chapter 15: Long-Term Capital Management What are Hedge Funds? The Rise of Long-Term Capital Management The Alchemy of Finance Relative Value or Convergence Trades The Central Bank of Volatility Straying Away from the Master Plan TheFallofLTCM The Rescue of LTCM The Moral of the Story

xviii

Global Derivative Debacles

Epilogue Bibliography Chapter 16: AIG Securitization and Credit Default Swaps What are Credit Default Swaps (CDS)? The Moral of the Story Chapter 17: From Theory to Malpractice: Lessons Learned Some First Principles Policy Recommendations for Non-financial Firms Policy Recommendations for Financial Institutions Policy Recommendations for Investors Policy Recommendations for Regulators Index

272 273 275 275 277 279 281 281 282 286 292 293 297