Financial Derivative Case Studies Essay

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INTRODUCTION

Financial derivatives have crept into the nations popular economic vocabulary on a wave of recent publicity about serious financial losses suffered by municipal governments, well-known corporations, banks and mutual funds that had invested in these products. Congress has held hearings on derivatives and financial commentators have spoken at length on the topic. Derivatives, however remain a type of financial instrument that few of us understand and fewer still fully appreciate, although many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products. In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently bad. When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy.

DERIVATIVES:

A derivative is a contractual relationship established by two (or more) parties where payment is based on (or derived from) some agreed-upon benchmark. Since individuals can create a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there is no definitive list of derivative products.

Why Have Derivatives?

Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes. For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party. More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators.

These investment managers may decide that it is more beneficial to assume a specific risk characteristic of a security. For instance, several derivative products may be created based on debt securities that represent an interest in a pool of residential home mortgages. One derivative product may provide that the purchaser receives only the interest payments made on the mortgages while another product may specify that the purchaser receives only the principal payments. These derivative products, which react differently to movements in interest rates, may have specific appeal to different investment strategies employed by investment managers.

The financial markets increasingly have become subject to greater swings in interest rate movements than in past decades. As a result, financial derivatives have appealed to corporate treasurers who wish to take advantage of favorable interest rates in the management of corporate debt without the expense of issuing new debt securities. For example, if a corporation has issued long term debt with an interest rate of 7 percent and current interest rates are 5 percent, the corporate treasurer may choose to exchange (i.e., Swap), interest rate payments on the long term debt for a floating interest rate, without disturbing the underlying principal amount of the debt itself.

RISK INVOLE IN DERIVATIVES:

There are four risk associated with derivatives.
* Market risk
* Operational risk
* Counter party credit risk
* Legal risk
Market risk:

The risk to earnings from adverse movements in market prices.
Operational risk:
The risk of losses occurring as a result of inadequate systems and control, human error, or management failure.
Counter party credit risk:
The risk that a party to a derivative contract will fail to perform on its obligation. Exposure to counterparty credit risk is determined by the cost of replacing a contract if a counterparty (as a party to a derivatives contract is known) were to default.

Legal risk:

The risk of loss because a contract is found not to be legally enforceable. Derivatives are legal contracts. Like any other contract, they require a legal infrastructure to provide for the resolution of conflicts and the enforcement of contract provisions.

CORPORATION:

BARING:

Barings PLC was the oldest merchant bank in Great Britain. Founded in 1762. With total shareholder equity of £440 million, it was far from the largest or most important banking organization in Great Britain. Barings had long enjoyed a reputation as a conservatively run institution. But that reputation was shattered on February 24, 1995, when Peter Baring, the banks chairman, contacted the Bank of England to explain that a trader in the firms Singapore futures subsidiary had lost huge sums of money speculating on Nikkei-225 stock index futures and options. In the days that followed, investigators found that the banks total losses exceeded US$1 billion, a sum large enough to bankrupt the institution.

STRATEGIES AND TRANSACTION:
CONTEXT:

In 1992, Barings sent Nicholas Leeson, a clerk from its London office, to manage the back-office accounting and settlement operations at its Singapore futures subsidiary. Baring Futures (Singapore), hereafter BFS, was established to enable Barings to execute trades on the Singapore International Monetary Exchange (SIMEX). The subsidiarys profits were expected to come primarily from brokerage commissions for trades executed on behalf of customers and other Barings subsidiaries. Most of BFSs business was concentrated in executing trades for a limited number of financial futures and options contracts.

These were the Nikkei-225 contract, the 10 year Japanese Government Bond (JGB) contract, the three-month Euroyen contract, and options on those contracts (known as futures options). The Nikkei-225 contract is a futures contract whose value is based on the Nikkei-225 stock index, an index of the aggregate value of the stocks of 225 of the largest corporations in Japan. The JGB contract is for the future delivery of ten-year Japanese government bonds. The Euroyen contract is a futures contract whose value is determined by changes in the three-month Euroyen deposit rate. A futures option is a contract that gives the buyer the right, but not the obligation, to buy or sell a futures contract at a stipulated price on or before some specified expiration date.

STRATEGIES:

During late 1992 or early 1993, Leeson was named general manager and head trader of BFS. Leeson never relieved his authority over the subsidiarys back-office operations when his responsibilities expanded including trading. Baringss management understood that such trading involved arbitrage in Nikkei-225 stock index futures and 10-year Japanese Government Bond (JGB) futures. Both contracts trade on SIMEX and the Osaka Securities Exchange (OSE). Leeson soon embarked upon a much riskier trading strategy. Rather than engaging in arbitrage, as Barings management believed, he began placing bets on the direction of price movements on the Tokyo stock exchange. Leesons reported trading profits were spectacular. His earnings soon came to account for a significant share of Barings total profits; the banks senior management regarded him as a star performer.

After Barings failed, however, investigators found that Leesons reported profits had been fictitious from the start. By manipulating information on his trading activity, Leeson was able to conceal his trading losses and report large profits instead. A major part of Leesons trading strategy involved the sale of options on Nikkei-225 futures contracts. The seller of an option earns a premium in return for accepting the obligation to buy or sell the underlying item at a stipulated strike price. If the option expires out-of-the money, the option premium becomes the sellers profit. If prices turn out to be more volatile than expected, however, an option sellers potential losses are virtually unlimited. Sometime in 1994, Leeson began selling large numbers of option straddles, a strategy that involved the simultaneous sale of both calls and puts on Nikkei-225 futures.

TRANSACTION:

Leesons trading losses from 1992 through the end of February 1995. By the end of 1992”just a few months after he had begun trading”Leeson had accumulated a hidden loss of £2 million. until October 1993, when his losses began to rise sharply. He lost another £21 million in 1993 and £185 million in 1994. Total cumulative losses at the end of 1994 stood at £208 million. That amount was slightly larger than the £205 million profit reported by the Barings Group as a whole, before accounting for taxes and for £102 million in scheduled bonuses. By January 1, 1995, Leeson was short 37,925 Nikkei calls and 32,967 Nikkei puts. He also held a long position of just over 1,000 contracts in Nikkei stock index futures, which would gain in value if the stock market were to rise.

WHAT WENT WRONG? HOW WAS THE LOSS ACCUMULATED?

Disaster struck on January 17 when news of a violent earthquake in Kobe, Japan, sent the Japanese stock market into a tailspin. Over the next five days, the Nikkei index fell over 1,500 points Leesons options positions sustained a loss of £68 million. As stock prices fell, he began buying massive amounts of Nikkei stock index futures. By February 6, the Japanese stock market had recovered by over 1,000 points, making it possible for Leeson to recoup most of the losses resulting from the markets reaction to the earthquake. cumulative losses on that date totaled £253 million, about 20 percent higher than they had been at the start of the year but within some days market began to fall again making losses to multiply. Barings faced massive margin calls as Leesons losses mounted. While these margin calls raised eyebrows at the banks London and Tokyo offices, they did not prompt an immediate inquiry into Leesons activities. It was not until February 6 that Baringss group treasurer, Tony Hawes, flew to Singapore to investigate irregularities with the accounts at BFS. Barings had committed a total of £742 million to finance margin calls for BFS.

WHO WAS RESPONSIBLE FOR THE LOSS?

Some observers blame this lack of communication on the rivalry between the two exchanges. Communication between SIMEX and the OSE was minimal, however this lack of communication not only helped make it possible for Leeson to accumulate large losses but also hampered efforts to contain the damage once Barings collapsed. The exchanges attitude toward Barings was influenced in part by the banks strong international reputation, but its willingness to relax normal risk management guidelines also may have been attributable to its desire to attract business.

Events surrounding the collapse of Barings have served to highlight weaknesses in risk management on the part of SIMEX and other futures exchanges. Barings collapse was due to the unauthorized and ultimately catastrophic activities of, it appears, one individual (Leeson) that went undetected as a consequence of a failure of management and other internal controls of the most basic kind. Management failed at various levels and in a variety of ways

WHAT LESSONS ARE TO BE LEARNED FROM THE CASE/ DISASTER?

HIGHLIGHTED WEAKNESS:

(1) The lack of communication between securities and futures exchanges and regulators in different countries, and (2) Conflicting laws on the legal status of customer accounts at futures brokers and clearing agents in the event of insolvency. These weaknesses can be addressed only by increased international cooperation among futures exchanges, regulators, and lawmakers.

* Management teams have a duty to understand fully the businesses they manage.

* Responsibility for each business activity has to be clearly established and communicated.

* Clear segregation of duties is fundamental to any effective control system.

* Relevant internal controls, including independent risk management, have to be established for all business activities.

* Top management and the Audit Committee have to ensure that significant weaknesses, identified to them by internal audit or otherwise, are resolved quickly.

METALLGESELLSCHAFT:

Metallgesellschaft AG (hereafter, MG) is a large industrial conglomerate engaged in a wide range of activities, from mining and engineering to trade and financial services. In December 1993, the firm reported huge derivatives-related losses at its U.S. oil subsidiary, Metallgesellschaft Refining and Marketing (MGRM).

STRATEGIES AND TRANSACTION:

CONTEXT:

In 1992, MGRM began implementing an aggressive marketing program in which it offered long-term price guarantees on deliveries of gasoline, heating oil, and diesel fuels for up to five or ten years. The first was a firm fixed program, under which a customer agreed to fixed monthly deliveries at fixed prices. The second, known as the firm-flexible contract, specified a fixed price and total volume of future deliveries but gave the customer some flexibility to set the delivery schedule.

STRATEGY:

By September 1993, MGRM had committed to sell forward the equivalent of over 150 million barrels of oil for delivery at fixed prices, with most contracts for terms of ten years. Both types of contracts included options for early termination. These cash-out provisions permitted customers to call for cash settlement on the full volume of outstanding deliveries if market prices for oil rose above the contracted price. Its contracted delivery prices reflected a premium of $3 to $5 per barrel over the prevailing spot price of oil. MGRM sought to offset the exposure resulting from its delivery commitments by buying a combination of short-dated oil swaps and futures contracts as part of a strategy known as a stack-and-roll hedge.

TRANSACTION:

In its simplest form, a stack-and-roll hedge involves repeatedly buying a bundle, or stack, of short dated futures or forward contracts to hedge a longer-term exposure. Each stack is rolled over just before expiration by selling the existing contracts while buying another stack of contracts for a more distant delivery date; hence the term stack-and-roll. MGRM implemented its hedging strategy by maintaining long positions in a wide variety of contract months, which it shifted between contracts for different oil products (crude oil, gasoline, and heating oil) in a manner intended to minimize the costs of rolling over its positions.

Had oil prices risen, the accompanying gain in the value of MGRMs hedge would have produced positive cash flows that would have offset losses stemming from its commitments to deliver oil at below-market prices. As it happened, however, oil prices fell even further in late 1993. Moreover, declines in spot and near-term oil futures and forward prices significantly exceeded declines in long-term forward prices. As a result, contemporaneous realized losses.

WHAT WENT WRONG? HOW WAS THE LOSS ACCUMULATED?

Decline in oil prices caused funding problems for MGRM. The practice in futures markets of marking futures contracts to market at the end of each trading session forced the firm to recognize its futures trading losses immediately, triggering huge margin calls. Normally, forward contracts have the advantage of permitting hedgers to defer recognition of losses on long-term commitments. But MGRMs stack-and-roll hedge substituted short-term forward contracts (in the form of short-term energy swaps maturing in late 1993) for long-term forward contracts. As these contracts matured, MGRM was forced to make large payments to its counterparties, putting further pressure on its cash flows. At the same time, most offsetting gains on its forward delivery commitments were deferred. MG reported losses of DM 1.8 billion on its operations for the fiscal year ended September 30, 1993, in addition to the DM 1.5 billion loss auditors attributed to its hedging program as of the same date.

WHO WAS RESPONSIBLE FOR THE LOSS?

MGs board of supervisors fired the firms chief executive and installed new management. The board instructed MGs new managers to begin liquidating MGRMs hedge and to enter into negotiations to cancel its long-term contracts with its customers. This action further complicated matters. The actions of MGs board of supervisors in this incident have spurred widespread debate and criticism, as well as several lawsuits. Some analysts argue that MGRMs hedging program was seriously flawed and that MGs board was right to terminate it. Others, including Nobel Prize-winning economist Merton Miller, argue that the hedging program was sound and that MGs board exacerbated any hedging-related losses by terminating the program too early.

WHAT LESSONS ARE TO BE LEARNED FROM THE CASE/ DISASTER?

Considering the debate over the merits of MGRMs hedging strategy, it would seem naive simply to blame the firms problems on its speculative use of derivatives. It is true that MGRMs hedging program was not without risks. But the firms losses are attributable more to operational risk”the risk of loss caused by inadequate systems and control or management failure”than to market risk. If MGs supervisory board is to be believed, the firms previous management lost control of the firm and then acted to conceal its losses from board members. If one sides with the firms previous managers (as well as with Culp, Hanke, and Miller), then the supervisory board and its bankers misjudged the risks associated with MGRMs hedging program and panicked when faced with large, short-term funding demands. Either way, the loss was attributable to poor management.

FINAL CONCLUSION OF BOTH CASES:

The cases of Metallgesellschaft and Barings provide an interesting study in contrasts. Both cases involve exchange-traded derivatives contracts. In both cases, senior management has been criticized for making an insufficient effort to understand fully the activities of their firms subsidiaries and for failing to monitor and supervise the activities of those subsidiaries adequately. But while critics have faulted MGs management for overreacting to the large margin calls faced by one of its subsidiaries, Baringss management has been faulted for being overly complacent in the face of a large number of warning signs. If these two disparate incidents offer any single lesson, it is the need for senior management to understand the nature of the firms activities and the risks that those activities involve.

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