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Risk Takers

Book Description

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.

Table of Contents

  1. Title Page
  2. Copyright
  3. Dedication
  4. About De|G PRESS
  5. Acknowledgments
  6. Contents
  7. Preface
  8. Chapter 1: Primer on Derivatives
    1. What Are Derivatives?
    2. Who Buys and Sells Derivatives?
    3. Where Are Derivative Contracts Bought and Sold?
    4. Two Major Types of Derivatives
      1. Forward Contracts
      2. Option Contracts
    5. Forward Contracts
      1. Long Forward in Action
      2. Short Forward in Action
    6. Options
      1. Call Options
      2. Put Options
      3. American versus European Options
      4. Examples of Puts and Calls in Action
    7. 4,000 Years of Derivatives
    8. Conclusion
    9. Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives
    10. Review Questions
    11. Bibliography
  9. Chapter 2: Employee Stock Options A User’s Guide
    1. ESOs: A Major Pillar of Executive Compensation
    2. Why Do Companies Use ESOs?
      1. Aligning Incentives
      2. Hiring and Retention
      3. Adjusting Compensation to Employee Risk Tolerance Levels
      4. Employee Tax Optimization
      5. Cash Flow Optimization
    3. Option Valuation Differences and Human Resource Management
    4. Problems with ESOs
      1. Employee Motivation
      2. Improving Performance
      3. Absolute Versus Relative Performance
    5. Possible Solutions to Employee Stock Option Problems
      1. Premium-Priced Stock Options
      2. Index Options
      3. Restricted Shares
      4. Omnibus Plans
      5. Conclusion
    6. Review Questions
    7. Bibliography
  10. Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows
    1. Metallgesellschaft: Evolution of the Company and Its Product Lines
    2. Energy Derivatives at MGRM
      1. Energy Markets on a Roller Coaster
    3. Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation?
    4. MGRM’S Innovative Energy Derivative Products
    5. MGRM’s Embedded Options
    6. Hedging MGRM’s Forward Energy Exposures
      1. Payoff Profile of a Short Forward Position
      2. The Ideal Hedge Was Not Available
      3. Physical Storage Hedge
      4. Stack-and-Roll Hedge
    7. Cash Flow Effects of a Stack-and-Roll Hedge
      1. Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months
    8. Stack-and-Roll Hedge Ratios
    9. MG Calls It Quits
    10. MGRM Butts Heads with NYMEX and the CFTC
    11. MGRM’S Profitability: It’s All in How You Account for It
    12. MGRM’S Credit Rating
    13. The Effects of an Itchy Trigger Finger
    14. Was MGRM Hedging or Speculating?
    15. Corporate Governance Issues
    16. Conclusion
    17. Review Questions
    18. Bibliography
  11. Chapter 4: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust
    1. P&G’s Motivation for the Swaps
      1. Motives for the U.S. Dollar–Denominated Interest Rate Swap
      2. Motives for the German Mark–Denominated Interest Rate Swap
      3. Motives for Using the Over-the-Counter Market
    2. The U.S. Dollar–Denominated Swap
      1. Plain Vanilla Swap
    3. P&G’s Gamble: The Speculative Side-Bet
      1. Viewing P&G’s Speculative Side-Bet as a Short Call Option
    4. Risk Notepad 4.1: Security Yield versus Price
      1. The Effect of Rising U.S. Interest Rates
      2. Losses on P&G’s U.S. Dollar Interest Rate Swap
    5. German Mark-Denominated Interest Rate Swap
    6. The Suit against Banker’s Trust
    7. Risk Notepad 4.2: Value at Risk
    8. The P&G-BT Settlement
    9. How Did BT Fare After the Swaps?
    10. P&G-BT from an Investor’s Perspective
    11. The Landmark P&G-BT Court Opinion
      1. Major Legal Issues
      2. An Unusual Court Opinion
      3. Summary of the Court Opinion
    12. Disclosure Reform after P&G-BT
    13. Should Corporate Treasuries Be Profit Centers?
    14. Conclusion
    15. Review Questions
    16. Bibliography
    17. Appendix 4.1: What Is an Interest Rate Swap?
  12. Chapter 5: Orange County The Largest Municipal Failure in U.S. History
    1. Robert Citron and the Orange County Board of Supervisors
    2. The Orange County Investment Pool
    3. The Major Risks Facing Assets in the OCIP Portfolio
      1. Credit Risk
      2. Market Risk
      3. Liquidity Risk
    4. OCIP’s Assets and Funding Sources
      1. Structured Notes
    5. Risk Notepad 5.1: Other Assets in the OCIP Portfolio
      1. Fixed-Income Securities
      2. OCIP’s Funding Sources
    6. Leveraging the OCIP Portfolio
    7. Effects of Leverage on OCIP’s Return
      1. OCIP’s Rising Returns: Effects of Falling Interest Rates
      2. OCIP’s Return Stabilizes: 1993
      3. OCIP’s Returns Plummet: 1994—Effects of Rising Interest Rates
    8. The Consequences
      1. Market Risk Causes Liquidity Risk
      2. Government Paralysis
      3. Citron Resigns
      4. Lack of Liquidity Leads to Bankruptcy
      5. Fire Sale of the OCIP Portfolio
    9. Monday-Morning Quarterbacking
      1. Was Orange County Truly a Derivative-Related Failure?
      2. Was Orange County Really Bankrupt?
      3. Was It a Mistake to Liquidate the OCIP Portfolio?
      4. Could the Debacle Have Been Predicted?
    10. Sentences, Blame, and Reform
      1. Robert Citron
      2. Other Players: Matthew Raabe and Merrill Lynch
      3. Stealth Supervision: Shared Blame
      4. Governance Reforms
    11. Lessons Learned from Orange County
      1. Safety, Liquidity, and High Yield Are an Impossible Combination
      2. If You Can’t Explain It, Then Don’t Do It
    12. Conclusion
    13. Review Questions
    14. Bibliography
  13. Chapter 6: Barings Bank PLC Leeson’s Lessons
    1. Barings Bank PLC
    2. Nick Leeson: From London to Jakarta to Singapore
    3. What Was Leeson Supposed to Be Doing at BFS?
    4. Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts?
    5. Five Eights Account
    6. Risk Notepad 6.2: Errors Accounts
    7. Leeson’s Trading Strategy: Doubling
    8. Risk Notepad 6.3: Doubling
    9. Funding Margin Calls
      1. Funding Source #1: Increasing Commission Income by Offering Deals at Non-Market Prices
      2. Funding Source #2: Using the Financial Resources of Barings as His Cash Cow
      3. Funding Source #3: Booking Fictitious Trades and Falsifying Records
      4. Funding Source #4: Selling Options
    10. Risk Notepad 6.4: Leeson’s Most Flagrant Falsification Scheme
    11. Net Profit/Loss Profile of Leeson’s Exposures
      1. Leeson’s Long Futures Positions
      2. Leeson’s Short Straddles
      3. Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract
      4. Profit/Loss Profile: Combining a Long Futures Position and “Numerous” Short Straddles
      5. Massive Purchases of Nikkei 225 Futures Contracts
    12. Beyond Irony: The Barings Failure in a Broader Time Frame
    13. A Bank for a Pound
    14. Aftermath of the Barings Failure
    15. How Could Barings Have Caught Leeson Sooner?
    16. Conclusions
    17. Review Questions
    18. Bibliography
  14. Chapter 7: Long-Term Capital Mismanagement “JM and the Arb Boys”
    1. Risk Notepad 7.1: What Is a Hedge Fund?
    2. LTCM: The Company
      1. The LTCM Business
      2. The Principals
    3. LTCM’S Strategy
      1. Identifying Small Market Imperfections
      2. Using a Minimum of Equity Capital
      3. Securing Long-Term Funding
      4. Charging Hefty Fees
    4. LTCM’S Impressive Performance: 1994–1997
    5. LTCM’S Contributions to Efficient Markets
    6. Why and How LTCM Failed
      1. Catalyst #1: Exogenous Macroeconomic Shocks
    7. Risk Notepad 7.2: What Is Contagion?
      1. Catalyst #2: Endogenous Shocks
    8. The Fed, Warren Buffett, and the Rescue of LTCM
    9. Risk Notepad 7.3: Another Look at Warren Buffett’s Offer for LTCM
    10. Conclusions and Lessons
      1. Be Careful What You Wish For
      2. Beware of Model Risk
      3. All for One and “1” for All
      4. Leverage Is a Fair-Weather Friend
      5. Financial Transparency Is the First Step in Meaningful Reform
      6. In the Long Run, Bet on Global Financial Market Efficiency
      7. You Can’t Float Without Liquidity
      8. Some Things Are Worth Doing for the Greater Good —
    11. Epilogue
      1. What Happened to the Principals, Creditors, Investors, and Consortium?
      2. The Principals and Employees
      3. Creditors and Investors
      4. The Consortium
    12. Review Questions
    13. Bibliography
    14. Appendix 7.1: Primer on LTCM’s Major Trades and Financial Instruments
    15. Appendix 7.2: UBS and the LTCM Warrant Deal
  15. Chapter 8: Amaranth Advisors LLC Using Natural Gas Derivatives to Bet on the Weather
    1. Amaranth Advisors LLC
    2. Natural Gas Markets
    3. Amaranth’s Natural Gas Trading Strategy and Performance: 2005–2006
      1. 2005: Using Long Calls to Bet on the Weather
      2. 2006: Using Futures and Spreads to Bet on the Weather
    4. Risk Notepad 8.1: Measuring Natural Gas and Putting Amaranth’s Positions into Perspective
    5. Risk Notepad 8.2: Primer on Spread Trades
    6. What Caused Amaranth’s Catastrophic Losses?
      1. Inadequate Risk Management Practices
      2. Lack of Liquidity
      3. Extraordinarily Large Movements in Market Prices
    7. Explosion or Implosion? Who Got Hurt?
    8. Questions Remaining After Amaranth’s Fall
      1. Did the Futures Markets Function Effectively?
      2. Did Amaranth Dominate the Natural Gas Futures Markets?
      3. Did Amaranth Engage in Excessive Speculation?
      4. Did Amaranth Commit Regulatory Arbitrage?
      5. Did Amaranth Manipulate the Price of Natural Gas?
    9. Risk Notepad 8.3: A Tale of Two Hedge Funds
    10. Conclusion
    11. Review Questions
    12. Bibliography
  16. Chapter 9: Société Générale and Rogue Trader Jérôme Kerviel
    1. Société Générale (SocGen)
    2. Jérôme Kerviel (JK)
    3. Back, Middle, and Front Office Jobs at SocGen
    4. Arbitraging Turbo Warrants
      1. What Are Plain Calls and Puts?
      2. What Are Turbo Warrants?
    5. How JK Built His Mountainous Positions
      1. 2005
      2. 2006
      3. 2007
      4. 2008
    6. JK’s Fraudulent Methods
      1. Gaining Unauthorized Access to SocGen’s Computer Systems
      2. Using Contract Cancellations and Modifications to Mask Positions and Risks
      3. Entering Pairs of Offsetting Trades at Artificial Prices
      4. Posting Intra-monthly “Provisions”
      5. Navigating SocGen’s Dysfunctional Risk Management System
      6. Exploiting Supervisor Turnover
    7. How JK Was Caught
    8. Paying the Piper
    9. Did SocGen Know about JK’s Fictitious Trades?
    10. Network Incentives: Why Did JK Go Undetected for So Long?
    11. SocGen’s Bonus Incentives
    12. Doubling Strategies, Prospect Theory, and Survival Theory
      1. Prospect and Survival Theory
    13. SocGen’s Risk Management Reforms
    14. Conclusion
    15. Review Questions
    16. Bibliography
  17. Chapter 10: AIG: Two Roads to Ruin
    1. AIG: The Company
    2. AIG-INV
    3. AIGFP
      1. Securitization: MBS, ABS, CDOs, and MBOs
      2. AIGFP’s Credit Derivative Portfolios
      3. Major Keys to AIGFP’s Initial Success
    4. AIG’s Chief Regulators
    5. What Went Wrong?
      1. AIG’s Credit Protection Exposures
      2. The Sources of AIGFP’s Liquidity Problems
    6. Securities Lending at AIG
      1. AIG’s Risky Securities Lending Operations
    7. AIG’s Bailout
    8. What If AIG Was Allowed to Fail?
      1. Regulatory Capital Risks
      2. AIG’s Insurance Affiliates’ Risks
      3. Contagion Risks
    9. Criticisms of the AIG Bailout
    10. Postscript
    11. Conclusion
    12. Review Questions
    13. Bibliography
    14. Appendix 10.1: Primer on Credit Derivatives
    15. Risk Notepad 10.1.1: The Long and Short of Credit Derivative Lingo
  18. Chapter 11: JPMorgan Chase and the “London Whale”
    1. JPMorgan & Company, the CIO, and the SCP
      1. JPM and JPM Bank
      2. The CIO
      3. The SCP
    2. The SCP Time Line
    3. Risk Notepad 11.1: What Are Risk-Weighted Assets?
    4. Risk Notepad 11.2: What Are the Basel Accords?
    5. What Went Wrong at the SCP?
      1. Mistake #1: Ignoring the SCP’s Strategic Purpose
      2. Mistake #2: A Failed Trading Strategy
      3. Mistake #3: Disregarding JPM Bank’s Internal and External Risk Measures
    6. Risk Notepad 11.3: The SCP’s Five Major Risk Measures
    7. Risk Notepad 11.4: Basel II.5 Accord’s Four New Risk Measures
      1. Mistake #4: Manipulating JPM Bank’s Risk Metrics
      2. Mistake #5: Publicly Misrepresenting the SCP’s Financial Condition
    8. Risk Notepad 11.5: What Is the Volcker Rule?
    9. Dysfunctional Regulation
    10. Conclusion
    11. Aftermath
    12. Risk Notepad 11.6: Aftermath
    13. Review Questions
    14. Bibliography
    15. Appendix 11.1: Alphabetical List of the Main “London Whale” Decision Makers and Players
    16. Appendix 11.2: Markit Group Limited
    17. Risk Notepad A 11.2.1: A Rosetta Stone for Understanding Markit Group’s Credit Indices and Abbreviations
  19. Index