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Risk Takers
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Risk Takers
by De Gruyter
Risk Takers
Title Page
Copyright
Dedication
About De|G PRESS
Acknowledgments
Contents
Preface
Chapter 1: Primer on Derivatives
What Are Derivatives?
Who Buys and Sells Derivatives?
Where Are Derivative Contracts Bought and Sold?
Two Major Types of Derivatives
Forward Contracts
Option Contracts
Forward Contracts
Long Forward in Action
Short Forward in Action
Options
Call Options
Put Options
American versus European Options
Examples of Puts and Calls in Action
4,000 Years of Derivatives
Conclusion
Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives
Review Questions
Bibliography
Chapter 2: Employee Stock Options A User’s Guide
ESOs: A Major Pillar of Executive Compensation
Why Do Companies Use ESOs?
Aligning Incentives
Hiring and Retention
Adjusting Compensation to Employee Risk Tolerance Levels
Employee Tax Optimization
Cash Flow Optimization
Option Valuation Differences and Human Resource Management
Problems with ESOs
Employee Motivation
Improving Performance
Absolute Versus Relative Performance
Possible Solutions to Employee Stock Option Problems
Premium-Priced Stock Options
Index Options
Restricted Shares
Omnibus Plans
Conclusion
Review Questions
Bibliography
Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows
Metallgesellschaft: Evolution of the Company and Its Product Lines
Energy Derivatives at MGRM
Energy Markets on a Roller Coaster
Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation?
MGRM’S Innovative Energy Derivative Products
MGRM’s Embedded Options
Hedging MGRM’s Forward Energy Exposures
Payoff Profile of a Short Forward Position
The Ideal Hedge Was Not Available
Physical Storage Hedge
Stack-and-Roll Hedge
Cash Flow Effects of a Stack-and-Roll Hedge
Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months
Stack-and-Roll Hedge Ratios
MG Calls It Quits
MGRM Butts Heads with NYMEX and the CFTC
MGRM’S Profitability: It’s All in How You Account for It
MGRM’S Credit Rating
The Effects of an Itchy Trigger Finger
Was MGRM Hedging or Speculating?
Corporate Governance Issues
Conclusion
Review Questions
Bibliography
Chapter 4: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust
P&G’s Motivation for the Swaps
Motives for the U.S. Dollar–Denominated Interest Rate Swap
Motives for the German Mark–Denominated Interest Rate Swap
Motives for Using the Over-the-Counter Market
The U.S. Dollar–Denominated Swap
Plain Vanilla Swap
P&G’s Gamble: The Speculative Side-Bet
Viewing P&G’s Speculative Side-Bet as a Short Call Option
Risk Notepad 4.1: Security Yield versus Price
The Effect of Rising U.S. Interest Rates
Losses on P&G’s U.S. Dollar Interest Rate Swap
German Mark-Denominated Interest Rate Swap
The Suit against Banker’s Trust
Risk Notepad 4.2: Value at Risk
The P&G-BT Settlement
How Did BT Fare After the Swaps?
P&G-BT from an Investor’s Perspective
The Landmark P&G-BT Court Opinion
Major Legal Issues
An Unusual Court Opinion
Summary of the Court Opinion
Disclosure Reform after P&G-BT
Should Corporate Treasuries Be Profit Centers?
Conclusion
Review Questions
Bibliography
Appendix 4.1: What Is an Interest Rate Swap?
Chapter 5: Orange County The Largest Municipal Failure in U.S. History
Robert Citron and the Orange County Board of Supervisors
The Orange County Investment Pool
The Major Risks Facing Assets in the OCIP Portfolio
Credit Risk
Market Risk
Liquidity Risk
OCIP’s Assets and Funding Sources
Structured Notes
Risk Notepad 5.1: Other Assets in the OCIP Portfolio
Fixed-Income Securities
OCIP’s Funding Sources
Leveraging the OCIP Portfolio
Effects of Leverage on OCIP’s Return
OCIP’s Rising Returns: Effects of Falling Interest Rates
OCIP’s Return Stabilizes: 1993
OCIP’s Returns Plummet: 1994—Effects of Rising Interest Rates
The Consequences
Market Risk Causes Liquidity Risk
Government Paralysis
Citron Resigns
Lack of Liquidity Leads to Bankruptcy
Fire Sale of the OCIP Portfolio
Monday-Morning Quarterbacking
Was Orange County Truly a Derivative-Related Failure?
Was Orange County Really Bankrupt?
Was It a Mistake to Liquidate the OCIP Portfolio?
Could the Debacle Have Been Predicted?
Sentences, Blame, and Reform
Robert Citron
Other Players: Matthew Raabe and Merrill Lynch
Stealth Supervision: Shared Blame
Governance Reforms
Lessons Learned from Orange County
Safety, Liquidity, and High Yield Are an Impossible Combination
If You Can’t Explain It, Then Don’t Do It
Conclusion
Review Questions
Bibliography
Chapter 6: Barings Bank PLC Leeson’s Lessons
Barings Bank PLC
Nick Leeson: From London to Jakarta to Singapore
What Was Leeson Supposed to Be Doing at BFS?
Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts?
Five Eights Account
Risk Notepad 6.2: Errors Accounts
Leeson’s Trading Strategy: Doubling
Risk Notepad 6.3: Doubling
Funding Margin Calls
Funding Source #1: Increasing Commission Income by Offering Deals at Non-Market Prices
Funding Source #2: Using the Financial Resources of Barings as His Cash Cow
Funding Source #3: Booking Fictitious Trades and Falsifying Records
Funding Source #4: Selling Options
Risk Notepad 6.4: Leeson’s Most Flagrant Falsification Scheme
Net Profit/Loss Profile of Leeson’s Exposures
Leeson’s Long Futures Positions
Leeson’s Short Straddles
Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract
Profit/Loss Profile: Combining a Long Futures Position and “Numerous” Short Straddles
Massive Purchases of Nikkei 225 Futures Contracts
Beyond Irony: The Barings Failure in a Broader Time Frame
A Bank for a Pound
Aftermath of the Barings Failure
How Could Barings Have Caught Leeson Sooner?
Conclusions
Review Questions
Bibliography
Chapter 7: Long-Term Capital Mismanagement “JM and the Arb Boys”
Risk Notepad 7.1: What Is a Hedge Fund?
LTCM: The Company
The LTCM Business
The Principals
LTCM’S Strategy
Identifying Small Market Imperfections
Using a Minimum of Equity Capital
Securing Long-Term Funding
Charging Hefty Fees
LTCM’S Impressive Performance: 1994–1997
LTCM’S Contributions to Efficient Markets
Why and How LTCM Failed
Catalyst #1: Exogenous Macroeconomic Shocks
Risk Notepad 7.2: What Is Contagion?
Catalyst #2: Endogenous Shocks
The Fed, Warren Buffett, and the Rescue of LTCM
Risk Notepad 7.3: Another Look at Warren Buffett’s Offer for LTCM
Conclusions and Lessons
Be Careful What You Wish For
Beware of Model Risk
All for One and “1” for All
Leverage Is a Fair-Weather Friend
Financial Transparency Is the First Step in Meaningful Reform
In the Long Run, Bet on Global Financial Market Efficiency
You Can’t Float Without Liquidity
Some Things Are Worth Doing for the Greater Good —
Epilogue
What Happened to the Principals, Creditors, Investors, and Consortium?
The Principals and Employees
Creditors and Investors
The Consortium
Review Questions
Bibliography
Appendix 7.1: Primer on LTCM’s Major Trades and Financial Instruments
Appendix 7.2: UBS and the LTCM Warrant Deal
Chapter 8: Amaranth Advisors LLC Using Natural Gas Derivatives to Bet on the Weather
Amaranth Advisors LLC
Natural Gas Markets
Amaranth’s Natural Gas Trading Strategy and Performance: 2005–2006
2005: Using Long Calls to Bet on the Weather
2006: Using Futures and Spreads to Bet on the Weather
Risk Notepad 8.1: Measuring Natural Gas and Putting Amaranth’s Positions into Perspective
Risk Notepad 8.2: Primer on Spread Trades
What Caused Amaranth’s Catastrophic Losses?
Inadequate Risk Management Practices
Lack of Liquidity
Extraordinarily Large Movements in Market Prices
Explosion or Implosion? Who Got Hurt?
Questions Remaining After Amaranth’s Fall
Did the Futures Markets Function Effectively?
Did Amaranth Dominate the Natural Gas Futures Markets?
Did Amaranth Engage in Excessive Speculation?
Did Amaranth Commit Regulatory Arbitrage?
Did Amaranth Manipulate the Price of Natural Gas?
Risk Notepad 8.3: A Tale of Two Hedge Funds
Conclusion
Review Questions
Bibliography
Chapter 9: Société Générale and Rogue Trader Jérôme Kerviel
Société Générale (SocGen)
Jérôme Kerviel (JK)
Back, Middle, and Front Office Jobs at SocGen
Arbitraging Turbo Warrants
What Are Plain Calls and Puts?
What Are Turbo Warrants?
How JK Built His Mountainous Positions
2005
2006
2007
2008
JK’s Fraudulent Methods
Gaining Unauthorized Access to SocGen’s Computer Systems
Using Contract Cancellations and Modifications to Mask Positions and Risks
Entering Pairs of Offsetting Trades at Artificial Prices
Posting Intra-monthly “Provisions”
Navigating SocGen’s Dysfunctional Risk Management System
Exploiting Supervisor Turnover
How JK Was Caught
Paying the Piper
Did SocGen Know about JK’s Fictitious Trades?
Network Incentives: Why Did JK Go Undetected for So Long?
SocGen’s Bonus Incentives
Doubling Strategies, Prospect Theory, and Survival Theory
Prospect and Survival Theory
SocGen’s Risk Management Reforms
Conclusion
Review Questions
Bibliography
Chapter 10: AIG: Two Roads to Ruin
AIG: The Company
AIG-INV
AIGFP
Securitization: MBS, ABS, CDOs, and MBOs
AIGFP’s Credit Derivative Portfolios
Major Keys to AIGFP’s Initial Success
AIG’s Chief Regulators
What Went Wrong?
AIG’s Credit Protection Exposures
The Sources of AIGFP’s Liquidity Problems
Securities Lending at AIG
AIG’s Risky Securities Lending Operations
AIG’s Bailout
What If AIG Was Allowed to Fail?
Regulatory Capital Risks
AIG’s Insurance Affiliates’ Risks
Contagion Risks
Criticisms of the AIG Bailout
Postscript
Conclusion
Review Questions
Bibliography
Appendix 10.1: Primer on Credit Derivatives
Risk Notepad 10.1.1: The Long and Short of Credit Derivative Lingo
Chapter 11: JPMorgan Chase and the “London Whale”
JPMorgan & Company, the CIO, and the SCP
JPM and JPM Bank
The CIO
The SCP
The SCP Time Line
Risk Notepad 11.1: What Are Risk-Weighted Assets?
Risk Notepad 11.2: What Are the Basel Accords?
What Went Wrong at the SCP?
Mistake #1: Ignoring the SCP’s Strategic Purpose
Mistake #2: A Failed Trading Strategy
Mistake #3: Disregarding JPM Bank’s Internal and External Risk Measures
Risk Notepad 11.3: The SCP’s Five Major Risk Measures
Risk Notepad 11.4: Basel II.5 Accord’s Four New Risk Measures
Mistake #4: Manipulating JPM Bank’s Risk Metrics
Mistake #5: Publicly Misrepresenting the SCP’s Financial Condition
Risk Notepad 11.5: What Is the Volcker Rule?
Dysfunctional Regulation
Conclusion
Aftermath
Risk Notepad 11.6: Aftermath
Review Questions
Bibliography
Appendix 11.1: Alphabetical List of the Main “London Whale” Decision Makers and Players
Appendix 11.2: Markit Group Limited
Risk Notepad A 11.2.1: A Rosetta Stone for Understanding Markit Group’s Credit Indices and Abbreviations
Index
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