Olivier jacque morgan stanley

GLOBAL DERIVATIVE DEBACLES

From Theory to Malpractice

Second Edition

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GLOBAL DERIVATIVE DEBACLES

From Theory to Malpractice

Second Edition

Laurent L Jacque Tufts University, USA & HEC School of Management, France

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Published by

World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE

Library of Congress Cataloging-in-Publication Data Jacque, Laurent L.

Global derivative debacles : from theory to malpractice / by Laurent L. Jacque. -- Second Edition.

pages cm Includes bibliographical references and index. ISBN 978-9814663243 (alk. paper) -- ISBN 978-9814663267 (alk. paper)

1. Derivative securities. 2. Finance. I. Title. HG6024.A3J335 2015 332.64’57--dc23

2015005685

British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library.

Copyright © 2015 by World Scientific Publishing Co. Pte. Ltd.

All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher.

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mailto:www.enquiries@stallionpress.com

A la mémoire de ma mère.

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PREFACE

At a time when the global financial system is engulfed into the mother of all financial crises, it is indeed tempting and opportune to charge derivatives for creating mayhem. Are derivatives indeed “the financial weapons of mass destruction” as vilified by Warren Buffet? This book is not another treatise on financial derivatives. The purpose of this project instead is to unlock the secrets of mystifying derivatives by telling the stories of institutions, which played in the derivative market and lost big. For some of them, it was honest but flawed financial engineering which brought them havoc. For others, it was unbridled speculation perpetrated by rogue traders, whose unchecked fraud brought their house down.

Each story is unique reflecting in part the idiosyncratic circumstances of derivative use and/or misuse but, as the reader will discover, a number of key themes keep reappearing under various guises: flawed financial engineering, poor auditing, ill-designed risk management and control systems, weak governance, old-fashioned fraud … Each chapter addresses one major derivative debacle by first narrating the story before deconstructing the financial architecture behind the debacle. In the process, the reader will become acquainted with institutions encompassing universal banks, hedge funds, industrial firms, trading companies and municipalities, and their lead character or villain. Like many I find myself mesmerized by the ingenuity of these infamous derivatives and the saga of powerful institutions in the hands of which they misfired: This book is their story.

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ACKNOWLEDGEMENTS

Over the years, research projects, consulting assignments and discussions with many savvy executives and academics have helped me challenge received wisdom in the area of financial engineering, risk management and derivatives: for their insight this book is a better one. Most notably I wish to thank Daniel Ades (Kawa Fund), Y.D. Ahn (Daewoo), Blaise Allaz (HEC), Bruce Benson (Barings), Alex Bongrain (Bongrain S.A.), Charles Bravler (Oliver Wyman), James Breech (Cougar Investments), Eric Bryis (Cyberlibris), Gaylen Byker (Inter-Oil Corporation), Brian Casabianca (International Finance Corporation), Asavin Chintakananda (Stock Exchange of Thailand), Georg Ehrensperger (Garantia), Myron Glucksman (Citicorp), Anthony Gribe (J.P. Hottinguer & Cie), Charamporn Jotishkatira (Thai Airways International), Minsoo Jung (Chatham Financial), Margaret Loebl (ADM), Robert Kiernan (Advanced Portfolio Management), Oliver Kratz (Global Thematic Partners), Rodney McLauchlan (Bankers Trust), Avinash Persaud (State Street), Gabriel Hawawini (INSEAD), Jacques Olivier (HEC), Craig Owen (Campbell Soup), Guadalupe Philips (Televisa), Christoph Schmid (Bio-Oils), Jorge Ramirez (Aon Risk Solutions), John Schwarz (Citicorp), Manoj Shahi, Pat Schena (Tufts University), Sung Cheng Shih (GIC, Singapore), Roland Portait (ESSEC), Rishad Sadikot (Cambridge Associates), Charles Tapiero (NYU Polytechnic School of Engineering), Adrian Tschoegl (Wharton School), Georgi Tsekov (Standard Chartered Bank), Philip Uhlmann (Bentley College), Seck Wai Kwong (State Street), Ibrahim Warde (Tufts University) and Lawrence Weiss (Tufts University).

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I am indebted to several individuals who selflessly read and edited several versions of the manuscript and wish to express my appreciation to David Aldama, Darius Haworon, Ellen MacDonald, Manoj Shahi, Scott Strand and Rajeev Sawant. Timely help for graphics and word-processing from Jordan Fabiansky, Martin Klupilek and Lupita Ervin is gratefully acknowledged. Last but not least I wish to thank my editor in chief — Olivier Jacque — who painstakingly reviewed the entire manuscript and asked all the hard questions.

Yet with so much help from so many I am still searching for the ultimate derivative which would hedge me from all remaining errors: but there is no escape — they are all mine.

LLJ Winchester and Paris

January 2015

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ABOUT THE AUTHOR

Laurent L. Jacque is the Walter B. Wriston Professor of International Finance & Banking at the Fletcher School of Law and Diplomacy (Tufts University) and Director of its International Business Studies Program. He previously served as Fletcher’s Academic Dean and as such was responsible for the design and the establishment of the new Master of International Business degree and the Center for Emerging Market Enterprises. Since 1990 he has also held a secondary appointment at the HEC School of Management (France) as a Professor of Economics, Finance, and International Business. Earlier, he served on the faculty of the Wharton School (University of Pennsylvania) for eleven years where he held a joint appointment in the Management and Finance departments and the Carlson School (University of Minnesota). He also held visiting appointment at Instituto de Empresa (Spain), Pacific Management Institute (University of Hawaii), Institut Superieur de Gestion (University of Tunis), Kiel Institute of World Economics (Germany), and Chulalongkorn University (Thailand) as The Sophonpanich Research Professor in Finance and Banking.

He is the author of four books, International Corporate Finance: Value Creation with Currency Derivatives in Global Capital Markets (John Wiley & Sons, 2014), Global Derivative Debacles: From Theory to Malpractice (World Scientific, 2010) translated in French, Russian, Chinese and Korean, Management and Control of Foreign Exchange Risk (Kluwer Academic Publishers, 1996), Management of Foreign Exchange Risk: Theory and Praxis (Lexington Books, 1978) as well as more than 25 articles on International Risk Management Multinational Control Systems, Capital Markets, which have appeared in the Journal of International Business Studies, Management Science, Journal of Risk and Insurance, Journal of Operations Research Society,

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Columbia Journal of World Business, Journal of Applied Corporate Finance, Insurance Mathematics and Economics, etc. He served as an advisor and consultant to the Foreign Exchange Rate Forecasting Service of Wharton Econometrics, Forecasting Associates and as a member of Water Technologies Inc.’s board of directors. He is currently serving as a senior advisor to the Bharti Institute of Public Policy (Indian School of Business) and is a member of the Institute’s advisory board.

A recipient of five teaching awards at The Wharton and Carlson Schools, Jacque also recently won the James L. Paddock award for teaching excellence at The Fletcher School and the Europe-wide HEC-CEMS award in 2008. He is a consultant to a number of firms and the IFC (World Bank) in the area of banking, corporate finance and risk management and has taught in many Management Development Programs, including Manufacturers Hanover Trust, Merck, Sharp & Dohme, Philadelphia National Bank, General Motors, Bunge and Born (Brazil), Rhone-Poulenc (France), Siam Commercial Bank (Thailand), Daewoo (South Korea), General Electric, Dupont de Nemours, Norwest Bank, Bangkok Bank (Thailand), INSEAD, Pechiney and Petrobras (Brazil).

Laurent Jacque is a graduate of HEC (Paris) and received his MA, MBA and PhD from the Wharton School (University of Pennsylvania).

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CONTENTS

Preface

Acknowledgements

About the Author

List of Figures

List of Tables

List of Boxes

Chapter 1: Derivatives and the Wealth of Nations

What are Derivatives?

A Brief History of Derivatives

Derivatives and the Wealth of Nations

Organization of the Book

Bibliography

PART I: FORWARDS

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Chapter 2: Showa Shell Sekiyu K.K.

“Shell-Shocked By Shell Games”: The Showa Shell Debacle

Hedging Currency Risk at Oil Companies

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

Was Showa Shell Hedging or Speculating?

Concealing Currency Losses

The Story Unfolds

Forecasting Exchange Rates: Treacherous at Best

The Moral of the Story

Chapter 3: Citibank’s Forex Losses

Currency Trading in the Tranquil Days of Bretton Woods

Gambling on Currencies with Forward Contracts

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

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

Hasty and Costly Conclusion

The Moral of the Story

Chapter 4: Bank Negara Malaysia

What is Central Banking All About?

Bank Negara as a Macro-Hedge Fund

How Did Bank Negara Speculate?

PART II: FUTURES

Chapter 5: Amaranth Advisors LLC

The Rise and Fall of Amaranth Advisors LLC

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Genesis of Natural Gas Derivatives

A Primer on Speculating in Natural Gas Derivatives

The Alchemy of Speculation Through Natural Gas Futures

The Story Unfolds: Amaranth Speculative Assault on Nymex

Risk Management at Amaranth

The Moral of the Story

Postscript

Chapter 6: Metallgesellschaft

The Metallgesellschaft Debacle

The “Long and Short” of Hedging in the Oil Market

Numerical Illustration of “Ebbs & Flows” Under a “Stack & Roll” Hedge

The “Message is in the Entrails”: Empirics of the Oil Market (1983–2002)

If Only MGRM had been Allowed to Roll the Dice

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

MGRM as a Market Maker

The Moral of the Story

Bibliography

Chapter 7: Sumitomo

Was Sumitomo Manipulating Copper Prices?

Alarm Bells

Debacle

Postscript

PART III: OPTIONS

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Chapter 8: Allied Lyons

A New Mission for Allied Lyons Treasury Department

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

Selling Volatility: Allied-Lyons “Deadly Game”

Alarm Bells are Ignored as the Story Unfolds

The Moral of the Story

Appendix: Pricing Currency Options

Chapter 9: Allied Irish Banks

Rusnak and Currency Trading at Allfirst

Gambling on Currencies with Forward Contracts

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

The Art of Concealment

When Alarm Bells are Ignored

The Moral of the Story

Epilogue

Bibliography

Chapter 10: Barings

The Rise and Fall of the House of Barings

Rogue Trader

Arbitrage

From Harmless Arbitrage to Lethal Speculation

A Primer on How to Speculate with Options

Financing Margin Calls by Selling Volatility

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Warning Bells

The Art of Concealment

The Moral of the Story: Leeson’s Seven Lessons

Epilogue

Bibliography

Chapter 11: Société Générale

The Making of a Rogue Trader

From Arbitrage to Directional Trades

Hasty Conclusion

When Alarm Bells are Ignored

The Art of Concealment

The Moral of the Story

Postscript

Bibliography

PART IV: SWAPS

Chapter 12: Procter & Gamble

How to Reduce Financing Costs with Levered Interest Rate Swaps

Embedded Options and Hidden Risks

Landmark Lawsuit

The Moral of the Story

Bibliography

Chapter 13: Gibson Greeting Cards

Chapter 14: Orange County

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Municipal Finance in Orange County

A Primer on Fixed Income Securities

Anatomy of Orange County Asset Portfolio

OCIP as a Hedge Fund

Double Jeopardy: How Orange County Collapsed

Was Filing for Bankruptcy Warranted?

The Moral of the Story

Epilogue

Bibliography

Chapter 15: Long-Term Capital Management

What are Hedge Funds?

The Rise of Long-Term Capital Management

The Alchemy of Finance

Relative Value or Convergence Trades

The Central Bank of Volatility

Straying Away from the Master Plan

The Fall of LTCM

The Rescue of LTCM

The Moral of the Story

Epilogue

Bibliography

Chapter 16: AIG

Securitization and Credit Default Swaps

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What are Credit Default Swaps (CDSs)?

A Stealth Hedge Fund at AIG

The Moral of the Story

Postscript

Chapter 17: JP Morgan Chase London Whale

The JP Morgan Chase Fortress

A Primer on Credit Default Swaps and Their Extended Family

The London Whale: The Story Unfolds

Hedge Funds Harpoon the London Whale

A Stealth Hedge Fund?

The Art of Concealment

The Moral of the Story

Postscript

Chapter 18: From Theory to Malpractice: Lessons Learned

Some First Principles

Policy Recommendations for Non-Financial Firms

Policy Recommendations for Financial Institutions

Policy Recommendations for Investors

Policy Recommendations for Regulators

Index

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LIST OF FIGURES

Chapter 1 Figure 1 Percent change in yen/USD exchange rate

Chapter 2 Figure 1 Monthly spot oil prices (1989–1993) Figure 2 Yen price of the dollar (1989–1994) Figure 3 Showa Shell’s economic exposure Figure 4 Forward rates as unbiased predictors of future spot exchange rates.

Monthly Data 30 day Forward vs. Spot Yen per Dollar

Chapter 3 Figure 1 $/£ exchange rate fluctuations (1964–1965) Figure 2 $/£ exchange rate vs. US and UK interest rates (1964–1965)

Chapter 5 Figure 1 Excessive Speculation in the Natural Gas Market Figure 2 Back-testing calendar spread speculation Figure 3 Natural gas futures prices Figure 4 U.S. natural gas, monthly production Figure 5 Natural gas in storage

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Figure 6 Amaranth’s outstanding futures positions Figure 7 Amaranth’s gas contracts for November Figure 8 Amaranth’s open interest in natural gas contracts Figure 9 January/November futures price spreads 2002–2006 Figure 10 Amaranth’s outstanding futures positions

Chapter 6 Figure 1 Unhedged “short” oil positions years 1–10 Figure 2 Hedged oil positions years 1–10 Figure 3 Stack of futures in year 0 to hedge short position years 1–10 Figure 4 Stack and roll Figure 5 (A) Example of a market in backwardation

(B) Example of a market in contango Figure 6 (A) Average monthly crude oil backwardation

(B) Average monthly heating oil backwardation (C) Average monthly gasoline backwardation

Figure 7 Cash flows from hedged oil deliveries Figure 8 Cash flows from “Stacking and Rolling” futures hedge

Chapter 8 Figure 1 Buying and writing put options Figure 2 Hedging with put options Figure 3 Buying and writing call options Figure 4 Writing a covered call option Figure 5 Value of a sterling call option prior of maturity Figure 6 Daily exchange rates (in US $/£) Figure 7 Daily volatility for US $/£ Figure 8 Writing a straddle Figure 9 Writing a strangle