Contents
Chapter 1:Primer on Derivatives
Who Buys and Sells Derivatives?
Where Are Derivative Contracts Bought and Sold?
Two Major Types of Derivatives
American versus European Options
Examples of Puts and Calls in Action
Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives
Chapter 2:Employee Stock Options A User’s Guide
ESOs: A Major Pillar of Executive Compensation
Adjusting Compensation to Employee Risk Tolerance Levels
Option Valuation Differences and Human Resource Management
Absolute Versus Relative Performance
Possible Solutions to Employee Stock Option Problems
Chapter 3:Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows
Metallgesellschaft: Evolution of the Company and Its Product Lines
Energy Markets on a Roller Coaster
Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation?
MGRM’S Innovative Energy Derivative Products
Hedging MGRM’s Forward Energy Exposures
Payoff Profile of a Short Forward Position
The Ideal Hedge Was Not Available
Cash Flow Effects of a Stack-and-Roll Hedge
Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months
MGRM Butts Heads with NYMEX and the CFTC
MGRM’S Profitability: It’s All in How You Account for It
The Effects of an Itchy Trigger Finger
Was MGRM Hedging or Speculating?
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
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
How Did BT Fare After the Swaps?
P&G-BT from an Investor’s Perspective
The Landmark P&G-BT Court Opinion
Disclosure Reform after P&G-BT
Should Corporate Treasuries Be Profit Centers?
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
OCIP’s Assets and Funding Sources
Risk Notepad 5.1: Other Assets in 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
Market Risk Causes Liquidity Risk
Lack of Liquidity Leads to Bankruptcy
Fire Sale of the OCIP Portfolio
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?
Other Players: Matthew Raabe and Merrill Lynch
Stealth Supervision: Shared Blame
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
Chapter 6:Barings Bank PLC Leeson’s Lessons
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?
Risk Notepad 6.2: Errors Accounts
Leeson’s Trading Strategy: Doubling
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
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
Aftermath of the Barings Failure
How Could Barings Have Caught Leeson Sooner?
Chapter 7:Long-Term Capital Mismanagement “JM and the Arb Boys”
Risk Notepad 7.1: What Is a Hedge Fund?
Identifying Small Market Imperfections
Using a Minimum of Equity Capital
LTCM’S Impressive Performance: 1994–1997
LTCM’S Contributions to Efficient Markets
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
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 —
What Happened to the Principals, Creditors, Investors, and Consortium?
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’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
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
Chapter 9:Société Générale and Rogue Trader Jérôme Kerviel
Back, Middle, and Front Office Jobs at SocGen
What Are Plain Calls and Puts?
How JK Built His Mountainous Positions
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
Did SocGen Know about JK’s Fictitious Trades?
Network Incentives: Why Did JK Go Undetected for So Long?
Doubling Strategies, Prospect Theory, and Survival Theory
SocGen’s Risk Management Reforms
Chapter 10:AIG: Two Roads to Ruin
Securitization: MBS, ABS, CDOs, and MBOs
AIGFP’s Credit Derivative Portfolios
Major Keys to AIGFP’s Initial Success
AIG’s Credit Protection Exposures
The Sources of AIGFP’s Liquidity Problems
AIG’s Risky Securities Lending Operations
What If AIG Was Allowed to Fail?
AIG’s Insurance Affiliates’ Risks
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
Risk Notepad 11.1: What Are Risk-Weighted Assets?
Risk Notepad 11.2: What Are the Basel Accords?
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?
Appendix 11.1: Alphabetical List of the Main “London Whale” Decision Makers and Players