DERIVATIVES AND THE WEALTH OF NATIONS
Derivatives are financial weapons of mass destruction.
At a time when the world economy is engulfed into the mother of all financial crises, it is indeed tempting and opportune to find derivatives guilty as charged for creating financial chaos. This book is not an indictment of financial derivatives to be feared as “financial weapons of mass destruction” nor is it a call for multilateral disarmament or signing a nonproliferation treaty! Derivatives may be feared but they cannot be avoided nor ignored (abstinence is not an option) as they permeate many of the key goods and services which are at the core of modern life: for example, the price of energy is largely influenced by oil and natural gas derivatives and the cost of securitized consumer finance (variable rate home mortgages and automobile loans) embodies interest rate derivatives and credit default swaps.
Instead this book recounts the financial debacles which — triggered by the misuse of derivatives — devastated both financial and nonfinancial firms. By presenting a factual analysis of how the malpractice of derivatives played havoc with derivative end-user and dealer institutions, a case is made for vigilance not only to market and counter-party risk, but also operational risk in their use for risk management and proprietary trading. Clear and recurring lessons across the different stories should be of immediate interest to financial managers, bankers, traders, auditors, and regulators who are directly or indirectly exposed to financial derivatives. The second purpose of this book is more modest: by telling real-life “horror” stories it purports to debunk
the mystifying pseudocomplexity of derivatives and to take the uninitiated reader on a “grand tour
” of financial engineering and derivatives. Indeed the reader is introduced step by step to real-life companies and the vicissitudes that they experienced in misusing the arcane derivatives.
WHAT ARE DERIVATIVES?
Derivatives are financial contracts, whose value is “derived” from the future price of an underlying asset such as currencies, commodities, interest rates, and stock price indices. Even though each chapter will introduce one specific derivative in much detail, it is helpful at this early stage to provide definitions for the four major families of derivatives, whose architecture is identical across different classes of underlying assets:
• Forwards are legally-binding contracts calling for the future delivery of an asset in an amount, at a price and at a date agreed upon today. For example, a 90-day forward purchase of 25 million pound sterling (£) at the forward rate of $1.47 = £1 signed on April 13, 2009 happens in two steps: today, April 13, 2009 a contract is signed spelling out the nature of the transaction (forward purchase of the pound sterling), the amount (£25 million), the price ($1.47), the time of delivery (90 days hence or July 17, 2009) but nothing happens physically beyond the exchange of legal promises. Ninety days later, the contract is executed by delivering £25 × 1.47 = $36.75 million and taking delivery of £25 million. The contract is carried out at the forward rate regardless of the spot price (that is the price prevailing on delivery day) of the pound sterling. Forwards are tailor-made contracts also known as over-the-counter and — as such — expose the signatories to counter-party risk — that is the risk that the other party may default on its delivery obligations. Forwards are available on commodities such as copper or oil and other assets. Forwards will be the “financial weapon of mass destruction” in the first three chapters involving respectively a major Japanese oil company Showa Shell, Citibank, and Bank Negara — the Central Bank of Malaysia.
are close cousins of forward contracts with some material differences. Futures are standardized contracts, whose amount and delivery date are set by an organized exchange: for example, sterling futures can only be delivered in March, June, September, and December (third Wednesday of calendar month) and are available in multiples of £62,500). The lack of flexibility in designing a tailor-made contract (as in the case of forwards) is compensated by the liquidity of the contract, which can be closed at any time before expiry. Because futures are entered with well-capitalized exchanges such as the Chicago Board of Trade or the New York Mercantile Exchange, there is no counterparty risk to be concerned with as the
exchange will require any contract holder to post a margin — a form of collateral — which ensures that the contract holder is able to fulfill the terms of the contract at all times regardless of the spot price. Futures will be the “financial weapon of mass destruction
” in Chapters 5
, and 7
featuring respectively the hedge fund Amaranth Advisors LLC, the German metal-processing and engineering firm Metallgesellschaft and the Japanese trading company Sumitomo.
are securities which give you the right to buy (call option) or sell (put option) an asset (currency, commodity, stocks, bonds) for an extended period (American option) or at a particular future point in time (European option) at an agreed price today (strike price) for an upfront cash-flow cost (premium). In one of the largest options ever contracted, U.K. company Enterprise Oil Ltd. paid more than $26 million for a 90-day currency option to protect against exchange rate fluctuations on $1.03 billion of the $1.45 billion that it had agreed to pay for the oil exploration and production assets of U.S.-based transportation company Texas Eastern Inc. The option — a dollar call option — gave Enterprise the right to buy dollars at a dollar/sterling rate of $1.70. The dollar/sterling exchange rate was $1.73 when Enterprise Oil bought the option on March 1: “We are bearish on sterling,” says group treasurer Justin Welby. “And we did a very careful calculation between the price of the option premium (which is cheaper the further out-of-the-money) and how much we could afford the dollar to strengthen. We decided that this was the best mix between the amount of protection we could forgo and the amount of up-front cash we were prepared to pay out for the option
” Ninety days later, the pound stood at $1.7505, which made the call option just about redundant at the modest cost of $26 million for Enterprise Oil Ltd. Options are available not only on currencies, but also on stock price indices, interest rates, and commodities. They are the “financial weapon of mass destruction
” in Chapters 8
, and 11
featuring respectively Allied Lyons, Barings Bank, Allied Irish Banks, and Société Générale.
• Swaps are contracts between two parties agreeing to exchange (swap) cash-flows over a determined period. The most common swaps are interest rate swaps — where one party pays a fixed interest rate based on a notional amount and the counter-party pays a floating rate keyed to the same notional amount. Cross-currency and commodity swaps are also common. Mexicana de Cobre — a Mexican copper-mining company — decided to hedge against volatile copper prices on the London Metal Exchange2
to secure medium-term financing at significantly more favorable terms than it was currently paying. It entered into a copper price swap with Metallgesellschaft (one of the leading metal-processing firms) whereby for a period of 3
years it committed to deliver monthly 4,000 metric tons of copper at a guaranteed price of $2,000 per metric ton regardless of the spot price on the world market. In effect the swap was tantamount to a portfolio of 36 forward contracts with maturities ranging from 1 to 36 months at a forward rate of $2,000 per metric ton. Most swaps are over-the-counter rather than exchange-traded. They are the “financial weapons of mass destruction
” in Chapters 12
featuring respectively Procter & Gamble, Gibson Greeting Cards, Orange County, Long-Term Capital Management and last but not least AIG.
A BRIEF HISTORY OF DERIVATIVES
From immemorial times, traders have been faced with three problems: how to finance the physical transportation of merchandise from point A to point B — perhaps several hundreds or thousands of miles apart and weeks or months away — how to insure the cargo (risk of being lost at sea or to pirates) and last, how to protect against price fluctuations in the value of the cargo across space (from point A to point B) and over time (between shipping and delivery time). In many ways, the history of derivatives contracts parallels the increasingly innovative remedies that traders devised in coping with their predicament.
Trade carried over great distance is probably as old as mankind and has long been a source of economic power for the nations which embraced it. Indeed international trade seems to have been at the vanguard of human progress and civilization: Phoenicians, Greeks, and Romans were all great traders, whose activities were facilitated by marketplaces and money changers which set fixed places and fixed times for exchanging goods. Some historians even claim that some form of contracting with future delivery appeared as early as several centuries BC. At about the same time in Babylonia — the cradle of civilization — commerce was primarily effected by means of caravans. Traders bought goods to be delivered in some distant location and sought financing. A risk-sharing agreement was designed whereby merchants-financiers provided a loan to traders, whose repayment was contingent upon safe delivery of the goods. The trader borrowed at a higher cost than ordinary loans would cost to account for the purchase of an “option to default” on the loan contingent upon loss of cargo. As lenders were offering similar options to many traders and thereby pooling their risks they were able to keep its cost affordable.3
Other forms of early derivatives contracts can be traced to medieval European commerce. After the long decline in commerce following the demise of the
Roman Empire, Medieval Europe experienced an economic reviv...