ITWASSOOTED: Gambling on Derivatives

Wednesday, March 18, 2009

Gambling on Derivatives

Gambling on Derivatives

Hedging Risk or Courting Disaster?

"It could rip your guts out overnight ... the biggest, most potentially lucrative, and destructive market in the world ."

Into the Fire new! by Linda Davies.
A new edition is out!

"In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial system to its knees."

Sir Julian Hodge

Memo, dated November 1990, to senior executives of the Cardiff-based Julian Hodge Bank, quoted in the Western Mail, Tuesday, February 28 1995.

"We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Warren Buffett

The world's greatest stock market investor, known as "the Sage of Omaha", in his Chairman's Letter in the Berkshire Hathaway 2002 Annual Report.

Unlike Warren Buffet, Sir Julian Hodge, the Welsh banker, issued his apocalyptic warning three years before the first rash of derivatives disasters involving Metallgesellschaft, Orange County, Sears Roebuck, Proctor & Gamble, happened in 1994. More was to come in 1995 in the form of the Daiwa and Barings scandals. None of those on their own, however, threatened to bring the world financial system to its knees. Until recently the crisis that came closest to doing so involved LTCM in September 1998. Nearly 10 years later, in March 2008, the FED took emergency action to avoid what was called derivatives Chernobyl. That action seemed to have worked ... for a while, but the Credit Crunch has raised worries, could a mega-catastrophe lie around the corner ...?

Financial Derivatives Timeline

12th Century

In European trade fairs sellers sign contracts promising future delivery of the items they sold.

What are Derivatives?

Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds. There are two main types: futures, or contracts for future delivery at a specified price, and options that give one party the opportunity to buy from or sell to the other side at a prearranged price.

Derivatives and Speculation

The job of a derivatives trader is like that of a bookie once removed, taking bets on people making bets.

The description above comes from In Into the Fire a novel about fraudulent trading in derivatives (now out in a new edition), by Linda Davies. Why on earth should anyone want to be a bookie once removed? The answer was given 63 years earlier by John Maynard Keynes in his best-known work.

Keynes on Speculation

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not the faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view."

"It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."

Keynes, John Maynard The general theory of employment, interest and money. London : Macmillan, St. Martin's Press, 1936. page 156.

Derivatives and the Nobel Prize for Economics

Although futures markets have existed in some form since at least the 17th century, modern futures markets developed in the 1850's with the opening of the Chicago Board of Trade. However, since the early 1970s financial futures markets dealing with currencies, shares and bonds have become much more important.

In 1971 the Bretton Woods system of fixed exchange rates broke down when the US suspended the convertibility of the dollar to gold. In a world of (mainly) floating exchange rates exporters and importers faced new risks. A couple of years later the Black-Scholes Model for determining the value of options was published. Its use caught on quickly and by the 1990s many financial institutions involved with derivatives were employing mathematicians and physicists to design ever more sophisticated financial instruments.

In 1997 the Royal Swedish Academy of Sciences awarded the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (the Nobel Prize for economics) to Professor Robert C. Merton of Harvard University and Professor Myron S. Scholes of Stanford University, Stanford for their method of determining the value of derivatives.

Merton and Scholes, in collaboration with the late Fischer Black, developed a pioneering formula for the valuation of stock options. Their methodology has paved the way for economic valuations in many areas. It has also generated new types of financial instruments and facilitated more efficient risk management in society.

The $3.5 Billion Rescue of LTCM

Just a year after Merton and Scholes received the Nobel Prize for their work a hedge fund in which they were among the principal shareholders, Long Term Capital Management, had to be rescued at a cost of $3.5 billion dollars as it was feared that its collapse could have had a disastrous effect on financial institutions around the world.

The Paradox of Hedging Risks

Why should a hedge fund that included two Nobel prize-winners among its principal shareholders make staggering losses by trading in financial instruments designed to reduce risk? There was, presumably, nothing wrong with the techniques themselves, just the way in which they were used. It is sometimes argued that measures to improve the safety of car occupants, e.g. seat belts, increase risk by encouraging drivers to go faster than they would without them.

It is possible that the sophisticated models that apparently enable risk to be accurately quantified encourage risk taking by financiers who would otherwise err on the side of caution. However that does not explain other scandals that have involved derivatives, e.g. the collapse of Barings Bank or the illegal trades in Swedish stocks by a member of the Flaming Ferraris.

Derivatives Traders and Gamblers

Keynes may have been exaggerating when he wrote about investors who practise the fourth, fifth and higher degrees of speculation. However, futures and options are highly geared, or leveraged, transactions and therefore traders/investors are able to assume large positions - with similar sized risks - with very little up-front outlay.

By their very nature they encourage those higher degrees of speculation so that derivatives traders behave, as Linda Davies wrote, like a bookie once removed. The potential rewards are such that a technique designed to reduce risk is all too often treated as a gambler's tool.

Mispriced Derivatives Scandals

Derivatives are sometimes deliberately mispriced in order to conceal losses or to make profits by fraud.

Mispriced options were used by NatWest Capital Markets to conceal losses and the British Securities and Futures Authority concluded its disciplinary action against the firm and two of its employees, Kyriacos Papouis and Neil Dodgson, in May 2000.

In March 2001 a Japanese court fined Credit Suisse First Boston 40 million yen because a subsidiary had used complex derivatives transactions to conceal losses.

In Seeing Tomorrow: rewriting the rules of risk by Ron S. Dembo and Andrew Freeman, a case in which "clever but criminal staff got inside an options pricing model and used tiny changes to skim off a few million dollars of profits for themselves" is described on page 23. The culprits were not prosecuted because the bank feared that the revelation could wipe out hundreds of millions of dollars of its overall value. This case is reminiscent of the plot of Into the Fire.

Another possible case came to light in January 2006 when Anshul Rustagi, a London-based derivatives trader at Deutsche Bank was suspended after allegedly overstating profits on his own trading book by £30 million. He was subsequently dismissed.

Toxic Derivatives and the Credit Crunch

The market in 2008 was worth over $516 trillion or about 10 times the value of the entire world's output. This enormous ticking time bomb threatens to wreck international efforts to solve the world's biggest financial crisis since the 1930s.

13th Century

There are many examples contracts entered into by English Cistercian Monestaries who frequently sold their wool up to 20 years in advance to foreign merchants.

Early 17th Century

1634-1637 Tulip Mania in Holland

Fortunes are lost in after a speculative boom in tulip futures burst.

Late 17th Century

Dojima Rice Futures

In Japan at Dojima, near Osaka a futures market in rice is developed to protect sellers from bad weather or warfare.

19th Century

1868 Chicago Board of Trade

Trading in wheat, pork belly and copper futures starts.

20th Century

Late 1960s - Black and Scholes begin collaboration

Fischer Black and Myron Scholes tackle the problem of determining how much an option is worth. Robert Merton joins them in 1970.

April 1973 The Chicago Board Options Exchange opens.
May/June 1973 The Black-Scholes Model is Published.

It appears in the Journal of Political Economy, one of the journals that had previously rejected it.

1994 Metallgesellshaft loses $1.5 billion on oil futures.
1995 Barings Bank goes bust.

Nick Leeson loses $1.4 billion by gambling that the Nikkei 225 index of leading Japanese company shares would not move materially from its normal trading range. That assumption was shattered by the Kobe earthquake on the 17th January 1995 after which Leeson attempted to conceal his losses.

1997 Nobel Prize in Economics awarded to Robert Merton and Myron Scholes.
1998 Long Term Credit Management Bailout

The hedge fund is rescued at a cost of $3.5 billion because of worries that its collapse would have severe repercussions for the world financial system.

1999 The Flaming Ferraris

Some traders at CSFB are sacked following allegations of illegal trades in an attempt to manipulate the Swedish stock market index.

21st Century

2001 Enron goes Bankrupt

The 7th largest company in the US and the world's largest energy trader made extensive use of energy and credit derivatives but becomes the biggest firm to go bankrupt in American history after systematically attempting to conceal huge losses.

2002 AIB loses $750 million

John Rusnak uses fictitious options contracts to cover loses on spot and forward foreign exchange contracts.

2003 Terrorism Futures Plan Dropped

The US Defense Department had thought that such a market would improve the prediction and prevention of terrorist outrages.

January 2004 NAB admits losing A$180 million

Four foreign currency dealers at the National Australia Bank are said to have run up the losses in three months of unauthorised trades.

August 2004 Citigroup bear raid

Citigroup traders led by Spiros Skordos made €15 million by suddenly selling €11 billion worth of European bonds and bond derivatives, and buying many of them back at a lower price.

November 2004 China Aviation loses $550m in speculative trade

This loss is the largest amount a company in Singapore has lost by betting on derivatives since the case of Nick Leeson and Barings.

October 2005 Refco suspends trading

One of the world's largest derivatives brokers is forced to freeze trades.

September 2006 Amaranth Advisors loses $6 billion

the US-based hedge fund suffered enormous loses trading in natural gas futures.

January 2008 Société Générale loses €4.9 billion in unauthorised futures trading

A rogue trader is blamed for the world's largest banking fraud up to that date.

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