book

Risk Takers

Name: Risk Takers
Author: John Marthinsen
ISBN: 9781547400058

by John Marthinsen

May 2018

Intermediate to advanced

386 pages

12h 17m

English

De Gruyter

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Title Page
Copyright
Dedication
About De|G PRESS
Acknowledgments
Contents
Preface
Chapter 1: Primer on Derivatives
What Are Derivatives?Who Buys and Sells Derivatives?Where Are Derivative Contracts Bought and Sold?Two Major Types of DerivativesForward ContractsOption ContractsForward ContractsLong Forward in ActionShort Forward in ActionOptionsCall OptionsPut OptionsAmerican versus European OptionsExamples of Puts and Calls in Action4,000 Years of DerivativesConclusionRisk Notepad 1.1: OTC-traded versus Exchange-Traded DerivativesReview QuestionsBibliography
Chapter 2: Employee Stock Options A User’s Guide
ESOs: A Major Pillar of Executive CompensationWhy Do Companies Use ESOs? Aligning IncentivesHiring and RetentionAdjusting Compensation to Employee Risk Tolerance LevelsEmployee Tax OptimizationCash Flow OptimizationOption Valuation Differences and Human Resource ManagementProblems with ESOs Employee MotivationImproving PerformanceAbsolute Versus Relative PerformancePossible Solutions to Employee Stock Option ProblemsPremium-Priced Stock OptionsIndex OptionsRestricted SharesOmnibus PlansConclusionReview QuestionsBibliography
Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows
Metallgesellschaft: Evolution of the Company and Its Product LinesEnergy Derivatives at MGRM Energy Markets on a Roller CoasterRisk Notepad 3.1: What Is the Difference Between Contango and Backwardation? MGRM’S Innovative Energy Derivative ProductsMGRM’s Embedded OptionsHedging MGRM’s Forward Energy ExposuresPayoff Profile of a Short Forward PositionThe Ideal Hedge Was Not AvailablePhysical Storage HedgeStack-and-Roll HedgeCash Flow Effects of a Stack-and-Roll HedgeScenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive MonthsStack-and-Roll Hedge RatiosMG Calls It QuitsMGRM Butts Heads with NYMEX and the CFTC MGRM’S Profitability: It’s All in How You Account for ItMGRM’S Credit RatingThe Effects of an Itchy Trigger FingerWas MGRM Hedging or Speculating?Corporate Governance IssuesConclusionReview QuestionsBibliography

Chapter 4: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust
P&G’s Motivation for the SwapsMotives for the U.S. Dollar–Denominated Interest Rate SwapMotives for the German Mark–Denominated Interest Rate SwapMotives for Using the Over-the-Counter MarketThe U.S. Dollar–Denominated SwapPlain Vanilla SwapP&G’s Gamble: The Speculative Side-BetViewing P&G’s Speculative Side-Bet as a Short Call OptionRisk Notepad 4.1: Security Yield versus PriceThe Effect of Rising U.S. Interest RatesLosses on P&G’s U.S. Dollar Interest Rate SwapGerman Mark-Denominated Interest Rate SwapThe Suit against Banker’s TrustRisk Notepad 4.2: Value at RiskThe P&G-BT SettlementHow Did BT Fare After the Swaps?P&G-BT from an Investor’s PerspectiveThe Landmark P&G-BT Court OpinionMajor Legal IssuesAn Unusual Court OpinionSummary of the Court OpinionDisclosure Reform after P&G-BTShould Corporate Treasuries Be Profit Centers?ConclusionReview QuestionsBibliographyAppendix 4.1: What Is an Interest Rate Swap?
Chapter 5: Orange County The Largest Municipal Failure in U.S. History
Robert Citron and the Orange County Board of SupervisorsThe Orange County Investment PoolThe Major Risks Facing Assets in the OCIP PortfolioCredit RiskMarket RiskLiquidity RiskOCIP’s Assets and Funding SourcesStructured NotesRisk Notepad 5.1: Other Assets in the OCIP PortfolioFixed-Income SecuritiesOCIP’s Funding SourcesLeveraging the OCIP PortfolioEffects of Leverage on OCIP’s ReturnOCIP’s Rising Returns: Effects of Falling Interest RatesOCIP’s Return Stabilizes: 1993OCIP’s Returns Plummet: 1994—Effects of Rising Interest RatesThe ConsequencesMarket Risk Causes Liquidity RiskGovernment ParalysisCitron ResignsLack of Liquidity Leads to BankruptcyFire Sale of the OCIP PortfolioMonday-Morning QuarterbackingWas Orange County Truly a Derivative-Related Failure?Was Orange County Really Bankrupt?Was It a Mistake to Liquidate the OCIP Portfolio?Could the Debacle Have Been Predicted?Sentences, Blame, and ReformRobert CitronOther Players: Matthew Raabe and Merrill LynchStealth Supervision: Shared BlameGovernance ReformsLessons Learned from Orange CountySafety, Liquidity, and High Yield Are an Impossible CombinationIf You Can’t Explain It, Then Don’t Do ItConclusionReview QuestionsBibliography
Chapter 6: Barings Bank PLC Leeson’s Lessons
Barings Bank PLC Nick Leeson: From London to Jakarta to SingaporeWhat Was Leeson Supposed to Be Doing at BFS? Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts?Five Eights AccountRisk Notepad 6.2: Errors AccountsLeeson’s Trading Strategy: DoublingRisk Notepad 6.3: DoublingFunding Margin CallsFunding Source #1: Increasing Commission Income by Offering Deals at Non-Market PricesFunding Source #2: Using the Financial Resources of Barings as His Cash CowFunding Source #3: Booking Fictitious Trades and Falsifying RecordsFunding Source #4: Selling OptionsRisk Notepad 6.4: Leeson’s Most Flagrant Falsification SchemeNet Profit/Loss Profile of Leeson’s ExposuresLeeson’s Long Futures PositionsLeeson’s Short StraddlesProfit/Loss Profile: Combining One Short Straddle and One Long Futures ContractProfit/Loss Profile: Combining a Long Futures Position and “Numerous” Short StraddlesMassive Purchases of Nikkei 225 Futures ContractsBeyond Irony: The Barings Failure in a Broader Time FrameA Bank for a PoundAftermath of the Barings FailureHow Could Barings Have Caught Leeson Sooner?ConclusionsReview QuestionsBibliography
Chapter 7: Long-Term Capital Mismanagement “JM and the Arb Boys”
Risk Notepad 7.1: What Is a Hedge Fund?LTCM: The CompanyThe LTCM BusinessThe PrincipalsLTCM’S StrategyIdentifying Small Market ImperfectionsUsing a Minimum of Equity CapitalSecuring Long-Term FundingCharging Hefty FeesLTCM’S Impressive Performance: 1994–1997LTCM’S Contributions to Efficient MarketsWhy and How LTCM FailedCatalyst #1: Exogenous Macroeconomic ShocksRisk Notepad 7.2: What Is Contagion?Catalyst #2: Endogenous ShocksThe Fed, Warren Buffett, and the Rescue of LTCM Risk Notepad 7.3: Another Look at Warren Buffett’s Offer for LTCM Conclusions and LessonsBe Careful What You Wish ForBeware of Model RiskAll for One and “1” for AllLeverage Is a Fair-Weather FriendFinancial Transparency Is the First Step in Meaningful ReformIn the Long Run, Bet on Global Financial Market EfficiencyYou Can’t Float Without LiquiditySome Things Are Worth Doing for the Greater Good — EpilogueWhat Happened to the Principals, Creditors, Investors, and Consortium?The Principals and EmployeesCreditors and InvestorsThe ConsortiumReview QuestionsBibliographyAppendix 7.1: Primer on LTCM’s Major Trades and Financial InstrumentsAppendix 7.2: UBS and the LTCM Warrant Deal
Chapter 8: Amaranth Advisors LLC Using Natural Gas Derivatives to Bet on the Weather
Amaranth Advisors LLC Natural Gas MarketsAmaranth’s Natural Gas Trading Strategy and Performance: 2005–20062005: Using Long Calls to Bet on the Weather2006: Using Futures and Spreads to Bet on the WeatherRisk Notepad 8.1: Measuring Natural Gas and Putting Amaranth’s Positions into PerspectiveRisk Notepad 8.2: Primer on Spread TradesWhat Caused Amaranth’s Catastrophic Losses?Inadequate Risk Management PracticesLack of LiquidityExtraordinarily Large Movements in Market PricesExplosion or Implosion? Who Got Hurt?Questions Remaining After Amaranth’s FallDid the Futures Markets Function Effectively?Did Amaranth Dominate the Natural Gas Futures Markets?Did Amaranth Engage in Excessive Speculation?Did Amaranth Commit Regulatory Arbitrage?Did Amaranth Manipulate the Price of Natural Gas?Risk Notepad 8.3: A Tale of Two Hedge FundsConclusionReview QuestionsBibliography
Chapter 9: Société Générale and Rogue Trader Jérôme Kerviel
Société Générale (SocGen)Jérôme Kerviel (JK)Back, Middle, and Front Office Jobs at SocGen Arbitraging Turbo WarrantsWhat Are Plain Calls and Puts?What Are Turbo Warrants?How JK Built His Mountainous Positions2005200620072008JK’s Fraudulent MethodsGaining Unauthorized Access to SocGen’s Computer SystemsUsing Contract Cancellations and Modifications to Mask Positions and RisksEntering Pairs of Offsetting Trades at Artificial PricesPosting Intra-monthly “Provisions”Navigating SocGen’s Dysfunctional Risk Management SystemExploiting Supervisor TurnoverHow JK Was CaughtPaying the PiperDid SocGen Know about JK’s Fictitious Trades?Network Incentives: Why Did JK Go Undetected for So Long?SocGen’s Bonus IncentivesDoubling Strategies, Prospect Theory, and Survival TheoryProspect and Survival TheorySocGen’s Risk Management ReformsConclusionReview QuestionsBibliography
Chapter 10: AIG: Two Roads to Ruin
AIG: The CompanyAIG-INVAIGFP Securitization: MBS, ABS, CDOs, and MBOs AIGFP’s Credit Derivative PortfoliosMajor Keys to AIGFP’s Initial SuccessAIG’s Chief RegulatorsWhat Went Wrong?AIG’s Credit Protection ExposuresThe Sources of AIGFP’s Liquidity ProblemsSecurities Lending at AIG AIG’s Risky Securities Lending OperationsAIG’s BailoutWhat If AIG Was Allowed to Fail?Regulatory Capital RisksAIG’s Insurance Affiliates’ RisksContagion RisksCriticisms of the AIG BailoutPostscriptConclusionReview QuestionsBibliographyAppendix 10.1: Primer on Credit DerivativesRisk Notepad 10.1.1: The Long and Short of Credit Derivative Lingo
Chapter 11: JPMorgan Chase and the “London Whale”
JPMorgan & Company, the CIO, and the SCP JPM and JPM BankThe CIO The SCP The SCP Time LineRisk Notepad 11.1: What Are Risk-Weighted Assets?Risk Notepad 11.2: What Are the Basel Accords?What Went Wrong at the SCP? Mistake #1: Ignoring the SCP’s Strategic PurposeMistake #2: A Failed Trading StrategyMistake #3: Disregarding JPM Bank’s Internal and External Risk MeasuresRisk Notepad 11.3: The SCP’s Five Major Risk MeasuresRisk Notepad 11.4: Basel II.5 Accord’s Four New Risk MeasuresMistake #4: Manipulating JPM Bank’s Risk MetricsMistake #5: Publicly Misrepresenting the SCP’s Financial ConditionRisk Notepad 11.5: What Is the Volcker Rule?Dysfunctional RegulationConclusionAftermathRisk Notepad 11.6: AftermathReview QuestionsBibliographyAppendix 11.1: Alphabetical List of the Main “London Whale” Decision Makers and PlayersAppendix 11.2: Markit Group LimitedRisk Notepad A 11.2.1: A Rosetta Stone for Understanding Markit Group’s Credit Indices and Abbreviations
Index

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.

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