Risk Takers: Uses and Abuses of Financial Derivatives

Risk Takers: Uses and Abuses of Financial Derivatives goes to the heart of the arcane and largely misunderstood world of derivative finance and makes it accessible to everyone—even novice readers. Marthinsen takes us behind the scenes, into the back alleyways of corporate finance and derivative trading, to provide a bird’s-eye view of the most shocking financial disasters of the past quarter century.

The book draws on real-life stories to explain how financial derivatives can be used to create or to destroy value. In an approachable, non-technical manner, Marthinsen brings these financial derivatives situations to life, fully exploring the context of each event, evaluating their outcomes, and bridging the gap between theory and practice.

1116751946
Risk Takers: Uses and Abuses of Financial Derivatives

Risk Takers: Uses and Abuses of Financial Derivatives goes to the heart of the arcane and largely misunderstood world of derivative finance and makes it accessible to everyone—even novice readers. Marthinsen takes us behind the scenes, into the back alleyways of corporate finance and derivative trading, to provide a bird’s-eye view of the most shocking financial disasters of the past quarter century.

The book draws on real-life stories to explain how financial derivatives can be used to create or to destroy value. In an approachable, non-technical manner, Marthinsen brings these financial derivatives situations to life, fully exploring the context of each event, evaluating their outcomes, and bridging the gap between theory and practice.

52.99 In Stock
Risk Takers: Uses and Abuses of Financial Derivatives

Risk Takers: Uses and Abuses of Financial Derivatives

by John Marthinsen
Risk Takers: Uses and Abuses of Financial Derivatives

Risk Takers: Uses and Abuses of Financial Derivatives

by John Marthinsen

eBook3rd ed. (3rd ed.)

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Overview

Risk Takers: Uses and Abuses of Financial Derivatives goes to the heart of the arcane and largely misunderstood world of derivative finance and makes it accessible to everyone—even novice readers. Marthinsen takes us behind the scenes, into the back alleyways of corporate finance and derivative trading, to provide a bird’s-eye view of the most shocking financial disasters of the past quarter century.

The book draws on real-life stories to explain how financial derivatives can be used to create or to destroy value. In an approachable, non-technical manner, Marthinsen brings these financial derivatives situations to life, fully exploring the context of each event, evaluating their outcomes, and bridging the gap between theory and practice.


Product Details

ISBN-13: 9781547400058
Publisher: De Gruyter
Publication date: 05/07/2018
Sold by: Barnes & Noble
Format: eBook
Pages: 386
Sales rank: 727,951
File size: 9 MB
Age Range: 18 Years

About the Author

John E. Marthinsen, Babson College, MA

Table of Contents

Chapter 1: Primer on Derivatives  1

What Are Derivatives?  1

Who Buys and Sells Derivatives?  2

Where Are Derivative Contracts Bought and Sold?  2

Two Major Types of Derivatives  3

Forward Contracts  3

Option Contracts  4

Forward Contracts  4

Long Forward in Action  5

Short Forward in Action  6

Options  7

Call Options  7

Put Options  8

American versus European Options  9

Examples of Puts and Calls in Action  9

4,000 Years of Derivatives  13

Conclusion  14

Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives  15

Review Questions  18

Bibliography  19

Chapter 2: Employee Stock OptionsA User’s Guide  21

ESOs: A Major Pillar of Executive Compensation  21

Why Do Companies Use ESOs?  22

Aligning Incentives  22

Hiring and Retention  23

Adjusting Compensation to Employee Risk Tolerance Levels  24

Employee Tax Optimization  24

Cash Flow Optimization  25

Option Valuation Differences and Human Resource Management  26

Problems with ESOs  37

Employee Motivation  38

Improving Performance  40

Absolute Versus Relative Performance  40

Possible Solutions to Employee Stock Option Problems  41

Premium-Priced Stock Options  41

Index Options  42

Restricted Shares  45

Omnibus Plans  45

Conclusion  46

Review Questions  46

Bibliography  47

Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows  51

Metallgesellschaft: Evolution of the Company and Its Product Lines  51

Energy Derivatives at MGRM  52

Energy Markets on a Roller Coaster  53

Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation?  55

MGRM’S Innovative Energy Derivative Products  56

MGRM’s Embedded Options  58

Hedging MGRM’s Forward Energy Exposures  59

Payoff Profile of a Short Forward Position  59

The Ideal Hedge Was Not Available  61

Physical Storage Hedge  61

Stack-and-Roll Hedge  62

Cash Flow Effects of a Stack-and-Roll Hedge  64

Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months  65

Stack-and-Roll Hedge Ratios  69

MG Calls It Quits  69

MGRM Butts Heads with NYMEX and the CFTC  70

MGRM’S Profitability: It’s All in How You Account for It  71

MGRM’S Credit Rating  72

The Effects of an Itchy Trigger Finger  72

Was MGRM Hedging or Speculating?  72

Corporate Governance Issues  73

Conclusion  74

Review Questions  75

Bibliography  76

Chapter 4: Swaps That Shook an Industry: Procter&Gamble versus Bankers Trust  77

P&G’s Motivation for the Swaps  78

Motives for the U.S. Dollar–Denominated Interest Rate Swap  79

Motives for the German Mark–Denominated Interest Rate Swap  80

Motives for Using the Over-the-Counter Market  80

The U.S. Dollar–Denominated Swap  81

Plain Vanilla Swap  82

P&G’s Gamble: The Speculative Side-Bet  83

Viewing P&G’s Speculative Side-Bet as a Short Call Option  84

Risk Notepad 4.1: Security Yield versus Price  86

The Effect of Rising U.S. Interest Rates  87

Losses on P&G’s U.S. Dollar Interest Rate Swap  91

German Mark-Denominated Interest Rate Swap  93

The Suit against Banker’s Trust  95

Risk Notepad 4.2: Value at Risk  97

The P&G-BT Settlement  98

How Did BT Fare After the Swaps?  98

P&G-BT from an Investor’s Perspective  99

The Landmark P&G-BT Court Opinion  100

Major Legal Issues  100

An Unusual Court Opinion  101

Summary of the Court Opinion  102

Disclosure Reform after P&G-BT  102

Should Corporate Treasuries Be Profit Centers?  103

Conclusion  103

Review Questions  104

Bibliography  105

Appendix 4.1: What Is an Interest Rate Swap?  107

Chapter 5: Orange CountyThe Largest Municipal Failure in U.S. History  109

Robert Citron and the Orange County Board of Supervisors  109

The Orange County Investment Pool  112

The Major Risks Facing Assets in the OCIP Portfolio  114

Credit Risk  115

Market Risk  115

Liquidity Risk  116

OCIP’s Assets and Funding Sources  117

Structured Notes  118

Risk Notepad 5.1: Other Assets in the OCIP Portfolio  118

Fixed-Income Securities  120

OCIP’s Funding Sources  120

Leveraging the OCIP Portfolio  123

Effects of Leverage on OCIP’s Return  124

OCIP’s Rising Returns: Effects of Falling Interest Rates  124

OCIP’s Return Stabilizes: 1993  126

OCIP’s Returns Plummet: 1994?Effects of Rising Interest Rates  127

The Consequences  128

Market Risk Causes Liquidity Risk  129

Government Paralysis  130

Citron Resigns  130

Lack of Liquidity Leads to Bankruptcy  130

Fire Sale of the OCIP Portfolio  131

Monday-Morning Quarterbacking  131

Was Orange County Truly a Derivative-Related Failure?  131

Was Orange County Really Bankrupt?  133

Was It a Mistake to Liquidate the OCIP Portfolio?  134

Could the Debacle Have Been Predicted?  135

Sentences, Blame, and Reform  136

Robert Citron  136

Other Players: Matthew Raabe and Merrill Lynch  137

Stealth Supervision: Shared Blame  138

Governance Reforms  139

Lessons Learned from Orange County  139

Safety, Liquidity, and High Yield Are an Impossible Combination  139

If You Can’t Explain It, Then Don’t Do It  140

Conclusion  141

Review Questions  141

Bibliography  142

Chapter 6: Barings Bank PLCLeeson’s Lessons  143

Barings Bank PLC  143

Nick Leeson: From London to Jakarta to Singapore  144

What Was Leeson Supposed to Be Doing at BFS?  145

Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts?  147

Five Eights Account  148

Risk Notepad 6.2: Errors Accounts  149

Leeson’s Trading Strategy: Doubling  150

Risk Notepad 6.3: Doubling  152

Funding Margin Calls  153

Funding Source #1: Increasing Commission Income by Offering Deals at Non-Market Prices  153

Funding Source #2: Using the Financial Resources of Barings as His Cash Cow  154

Funding Source #3: Booking Fictitious Trades and Falsifying Records  155

Funding Source #4: Selling Options  156

Risk Notepad 6.4: Leeson’s Most Flagrant Falsification Scheme  156

Net Profit/Loss Profile of Leeson’s Exposures  157

Leeson’s Long Futures Positions  157

Leeson’s Short Straddles  159

Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract  161

Profit/Loss Profile: Combining a Long Futures Position and "Numerous" Short Straddles  162

Massive Purchases of Nikkei 225 Futures Contracts  163

Beyond Irony: The Barings Failure in a Broader Time Frame  164

A Bank for a Pound  165

Aftermath of the Barings Failure  167

How Could Barings Have Caught Leeson Sooner?  168

Conclusions  171

Review Questions  172

Bibliography  173

Chapter 7: Long-Term Capital Mismanagement"JM and the Arb Boys"  175

Risk Notepad 7.1: What Is a Hedge Fund?  176

LTCM: The Company  177

The LTCM Business  177

The Principals  177

LTCM’S Strategy  179

Identifying Small Market Imperfections  179

Using a Minimum of Equity Capital  180

Securing Long-Term Funding  184

Charging Hefty Fees  186

LTCM’S Impressive Performance: 1994–1997  186

LTCM’S Contributions to Efficient Markets  189

Why and How LTCM Failed  190

Catalyst #1: Exogenous Macroeconomic Shocks  190

Risk Notepad 7.2: What Is Contagion?  192

Catalyst #2: Endogenous Shocks  193

The Fed, Warren Buffett, and the Rescue of LTCM  198

Risk Notepad 7.3: Another Look at Warren Buffett’s Offer for LTCM  200

Conclusions and Lessons  202

Be Careful What You Wish For  203

Beware of Model Risk  203

All for One and "1" for All  203

Leverage Is a Fair-Weather Friend  204

Financial Transparency Is the First Step in Meaningful Reform  204

In the Long Run, Bet on Global Financial Market Efficiency  205

You Can’t Float Without Liquidity  205

Some Things Are Worth Doing for the Greater Good 205

Epilogue  206

What Happened to the Principals, Creditors, Investors, and Consortium?  206

The Principals and Employees  206

Creditors and Investors  207

The Consortium  207

Review Questions  208

Bibliography  208

Appendix 7.1: Primer on LTCM’s Major Trades and Financial Instruments  210

Appendix 7.2: UBS and the LTCM Warrant Deal  213

Chapter 8: Amaranth Advisors LLCUsing Natural Gas Derivatives to Bet on the Weather  217

Amaranth Advisors LLC  217

Natural Gas Markets  219

Amaranth’s Natural Gas Trading Strategy and Performance: 2005–2006  222

2005: Using Long Calls to Bet on the Weather  222

2006: Using Futures and Spreads to Bet on the Weather  223

Risk Notepad 8.1: Measuring Natural Gas and Putting Amaranth’s Positions into Perspective  227

Risk Notepad 8.2: Primer on Spread Trades  228

What Caused Amaranth’s Catastrophic Losses?  234

Inadequate Risk Management Practices  234

Lack of Liquidity  236

Extraordinarily Large Movements in Market Prices  238

Explosion or Implosion? Who Got Hurt?  238

Questions Remaining After Amaranth’s Fall  240

Did the Futures Markets Function Effectively?  240

Did Amaranth Dominate the Natural Gas Futures Markets?  240

Did Amaranth Engage in Excessive Speculation?  243

Did Amaranth Commit Regulatory Arbitrage?  244

Did Amaranth Manipulate the Price of Natural Gas?  245

Risk Notepad 8.3: A Tale of Two Hedge Funds  248

Conclusion  254

Review Questions  255

Bibliography  256

Chapter 9: Société Générale and Rogue Trader Jérôme Kerviel  259

Société Générale (SocGen)  259

Jérôme Kerviel (JK)  259

Back, Middle, and Front Office Jobs at SocGen  260

Arbitraging Turbo Warrants  261

What Are Plain Calls and Puts?  261

What Are Turbo Warrants?  262

How JK Built His Mountainous Positions  265

2005  265

2006  266

2007  267

2008  269

JK’s Fraudulent Methods  269

Gaining Unauthorized Access to SocGen’s Computer Systems  270

Using Contract Cancellations and Modifications to Mask Positions and Risks  270

Entering Pairs of Offsetting Trades at Artificial Prices  271

Posting Intra-monthly "Provisions"  271

Navigating SocGen’s Dysfunctional Risk Management System  271

Exploiting Supervisor Turnover  273

How JK Was Caught  274

Paying the Piper  275

Did SocGen Know about JK’s Fictitious Trades?  276

Network Incentives: Why Did JK Go Undetected for So Long?  278

SocGen’s Bonus Incentives  279

Doubling Strategies, Prospect Theory, and Survival Theory  280

Prospect and Survival Theory  281

SocGen’s Risk Management Reforms  282

Conclusion  283

Review Questions  284

Bibliography  284

Chapter 10: AIG: Two Roads to Ruin

AIG: The Company  288

AIG-INV  289

AIGFP  289

Securitization: MBS, ABS, CDOs, and MBOs  290

AIGFP’s Credit Derivative Portfolios  292

Major Keys to AIGFP’s Initial Success  294

AIG’s Chief Regulators  294

What Went Wrong?  295

AIG’s Credit Protection Exposures  296

The Sources of AIGFP’s Liquidity Problems  298

Securities Lending at AIG  301

AIG’s Risky Securities Lending Operations  304

AIG’s Bailout  306

What If AIG Was Allowed to Fail?  310

Regulatory Capital Risks  310

AIG’s Insurance Affiliates’ Risks  311

Contagion Risks  311

Criticisms of the AIG Bailout  312

Postscript  313

Conclusion  314

Review Questions  316

Bibliography  316

Appendix 10.1: Primer on Credit Derivatives  318

Risk Notepad 10.1.1: The Long and Short of Credit Derivative Lingo  318

Chapter 11: JPMorgan Chase and the "London Whale"  323

JPMorgan&Company, the CIO, and the SCP  324

JPM and JPM Bank  324

The CIO  325

The SCP  326

The SCP Time Line  327

Risk Notepad 11.1: What Are Risk-Weighted Assets?  329

Risk Notepad 11.2: What Are the Basel Accords?  330

What Went Wrong at the SCP?  330

Mistake #1: Ignoring the SCP’s Strategic Purpose  331

Mistake #2: A Failed Trading Strategy  332

Mistake #3: Disregarding JPM Bank’s Internal and External Risk Measures  336

Risk Notepad 11.3: The SCP’s Five Major Risk Measures  337

Risk Notepad 11.4: Basel II.5 Accord’s Four New Risk Measures  338

Mistake #4: Manipulating JPM Bank’s Risk Metrics  339

Mistake #5: Publicly Misrepresenting the SCP’s Financial Condition  341

Risk Notepad 11.5: What Is the Volcker Rule?  341

Dysfunctional Regulation  342

Conclusion  343

Aftermath  344

Risk Notepad 11.6: Aftermath  345

Review Questions  346

Bibliography  346

Appendix 11.1: Alphabetical List of the Main "London Whale" Decision Makers and Players  347

Appendix 11.2: Markit Group Limited  348

Risk Notepad A 11.2.1: A Rosetta Stone for Understanding Markit Group’s Credit Indices and Abbreviations  348

Index  351

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