Table of Contents

Preface vii

Acknowledgments ix

About the Author xi

List of Figures xix

List of Tables xxiii

List of Boxes xv

Chapter 1 Derivatives and the Wealth of Nations 1

What are Derivatives? 2

A Brief History of Derivatives 4

Derivatives and the Wealth of Nations 8

Organization of the Book 9

Bibliography 11

Part I Forwards 13

Chapter 2 Showa Shell Sekiyu K.K. 15

Hedging Currency Risk at Oil Companies 16

The Mechanics of Hedging Dollar Exchange Rate Risk and Oil Price Risk 19

Was Showa Shell Hedging or Speculating? 21

Concealing Currency Losses 22

The Story Unfolds 22

Forecasting Exchange Rates: Treacherous at Best 23

The Moral of the Story 25

Chapter 3 Citibank's Forex Losses 29

Currency Trading in the Tranquil Days of Bretton Woods 30

Gambling on Currencies with Forward Contracts 32

How Do Banks Keep a Lid on Their Foreign Exchange Trading Operations 33

Speculating from a Commercial Bank's Trading Desk: When Citibank is Not Quite a Hedge Fund a La Georges Soros 35

Hasty and Costly Conclusion 38

The Moral of the Story 39

Chapter 4 Bank Negara Malaysia 41

What is Central Banking All About? 42

Bank Negara as a Macro-Hedge Fund 43

How Did Bank Negara Speculate? 44

Part II Futures 47

Chapter 5 Amaranth Advisors LLC 49

The Rise and Fall of Amaranth Advisors LLC 50

Genesis of Natural Gas Derivatives 52

A Primer on Speculating in Natural Gas Derivatives 53

The Alchemy of Speculation Through Natural Gas Futures 58

The Story Unfolds: Amaranth Speclative Assault on Nymex 60

Risk Management at Amaranth 68

The Moral of the Story 70

Postscript 71

Chapter 6 Metallgesellschaft 73

The Metallgesellschaft Debacle 74

The "Long and Short" of Hedging in the Oil Market 77

Numerical Illustration of "Ebbs & Flows" Under a "Stack & Roll" Hedge 83

The "Message is in the Entrails": Empirics of the Oil Market (1983-2002) 85

If Only MGRM Had Been Allowed to Roll the Dice 89

When a Hedge is a Gamble: Was MGRM Hedging or Speculating? 92

MGRM as a Market Maker 93

The Moral of the Story 94

Bibliography 96

Chapter 7 Sumitomo 97

Was Sumitomo Manipulating Copper Prices? 98

Alarm Bells 100

Debacle 101

Postscript 101

Part III Options 103

Chapter 8 Allied Lyons 105

A New Mission for Allied Lyons Treasury Department 106

A Primer on Currency Options: Was Allied Lyons Hedging or Speculating? 109

Selling Volatility: Allied-Lyons "Deadly Game" 115

Alarm Bells are Ignored as the Story Unfolds 121

The Moral of the Story 122

Appendix: Pricing Currency Options 123

Chapter 9 Allied Irish Banks 125

Rusnak and Currency Trading at Allfirst 125

Gambling on Currencies with Forward Contracts 127

Arbitraging the Forward and Option Market: The International Put-Call Parity Theorem 129

The Art of Concealment 133

When Alarm Bells are Ignored 137

The Moral of the Story 139

Epilogue 140

Bibliography 140

Chapter 10 Barings 143

The Rise and Fall of the House of Barings 144

Rogue Trader 146

Arbitrage 148

From Harmless Arbitrage to Lethal Speculation 151

A Primer on How to Speculate with Options 156

Financing Margin Calls by Selling Volatility 161

Warning Bells 168

The Art of Concealment 169

The Moral of the Story: Leeson's Seven Lessons 174

Epilogue 177

Bibliography 177

Chapter 11 Société Générale 179

The Making of a Rogue Trader 179

From Arbitrage to Directional Trades 182

Hasty Conclusion 188

When Alarm Bells are Ignored 190

The Art of Concealment 192

The Moral of the Story 192

Postscript 195

Bibliography 196

Part IV Swaps 197

Chapter 12 Procter & Gamble 199

How to Reduce Financing Costs with Levered Interest Rate Swaps 200

Embedded Options and Hidden Risks 206

Landmark Lawsuit 210

The Moral of the Story 213

Bibliography 214

Chapter 13 Gibson Greeting Cards 217

Chapter 14 Orange County 221

Municipal Finance in Orange County 222

A Primer on Fixed Income Securities 224

Anatomy of Orange County Asset Portfolio 227

OCIP as a Hedge Fund 232

Double Jeopardy: How Orange County Collapsed 236

Was Filing for Bankruptcy Warranted? 237

The Moral of the Story 239

Epilogue 242

Bibliography 244

Chapter 15 Long-Term Capital Management 245

What are Hedge Funds? 246

The Rise of Long-Term Capital Management 247

The Alchemy of Finance 249

Relative Value or Convergence Trades 252

The Central Bank of Volatility 257

Straying Away from the Master Plan 263

The Fall of LTCM 264

The Rescue of LTCM 267

The Moral of the Story 270

Epilogue 272

Bibliography 273

Chapter 16 AIG 275

Securitization and Credit Default Swaps 275

What are Credit Default Swaps (CDS)? 277

The Moral of the Story 279

Chapter 17 From Theory to Malpractice: Lessons Learned 281

Some First Principles 281

Policy Recommendations for Non-financial Firms 282

Policy Recommendations for Financial Institutions 286

Policy Recommendations for Investors 292

Policy Recommendations for Regulators 293

Index 297