Disasters in derivative Markets (2)

SWATI SESHADRI (118)NIKHIL R BHATIA (405)

AYON CHOWDHURY (203) ANURAG ARYA (202)

MANISH KUMAR (111)

Disasters in Derivative Markets

Content

1. Introduction2. Overview of the Global derivative market.3. Why derivative disasters occur4. A few disasters

1. Nick Leeson 2. Amarnath Advisors3. Long Term Capital Management

5. Learnings

What Is A Derivative?

ThenAny financial instrument whose value depends on

value(s) of the assets underlying the derivative

NowAny financial instrument whose value depends on

value(s) of the assets (transparent and/or latent) underlying the derivative

Weapons Of Mass Destruction (WMD) – Bershire’s 2002 Annual Report

From the “Experts”

The derivatives genie is now well out of the bottle, and these instruments will almost

certainly multiply in variety and number until some event makes their toxicity clear....[They]

are financial weapons of mass destruction, carrying dangers that, while now latent, are

potentially lethal. Warren Buffett

Global Derivative Market

The derivatives are highly leveraged.

OTC Account for more than 70% of the derivative

market.

OTC VS ETD

Regulated Markets

Settlement System

Standardization

Guarantee of completion of

operations

Non-Regulated Markets

Bilateral Agreements

No-Standardizat

ion

Risk of counterparty

OTC

ETD

Disasters in Derivative Markets: Reasons

Over dependence on mathematical models. Get out of excel sheets move to market reality.

Highly leveraged positions.

Market assumptions are mostly not fair and realistic.

Off-balance sheet transactions.

Over-dependence on historical data.

Derivatives are largely created out of thin air. Practically speaking, they have no value in and of themselves.

They are also hard to understand (Complex)

Disasters in Derivative Markets

Though trading systems have implemented great transparency but the vast majority of deals are private, "over-the-counter" transactions that go unreported.

Control in hands of an individual or group with no supervision. (Ex. Barring’s Bank case)

Liberalization and globalization of financial markets, has added to potential disasters due to increasing competition.

Hedge funds, insurers, corporate treasuries, the finance arms of industrial companies, and other non-traditional players are increasingly involved in the derivatives market. Further adding to complexity.

There are more inexperienced players taking part, more firms with diverse -- and occasionally inadequate -- capabilities linked to each other, and a maze of overlapping and often competing jurisdictions.

Case 1:Baring’s Bank and Nick Leeson

Introduction

February 26, 1995 Baring Brothers & Co. collapsed, reducing in

value from $500 million to $1.60 February 26, 1995, Barings had outstanding

notional futures positions of US$27 billion

The culprit 28 year-old rogue trader, Nicholas Leeson

Leeson’s Responsibilities

Leeson arrived at  Baring Securities (Singapore) Limited (BSS) in 1992

He was general manager, head trader and head of the back office (operations)

Leeson had authority to perform two types of trading: transacting futures and options orders for clients or

for other firms within the Barings organization, and riskless arbitraging of price differences between

Nikkei futures traded on the SIMEX and Japan's Osaka exchange

FUTURE CONTRACTS

Greatly impacted by the Kobe earthquake of January 17.

Lesson's positions went in the opposite direction to the Nikkei

Before the Kobe earthquake, with the Nikkei trading in a range of 19,000 to 19,500, Leeson had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange.

After the earthquake Leeson started an aggressive buying programme which culminated in a high of 19,094 contracts reached about a month later on February 17.

FUTURE CONTRACT

 Leeson's official trading strategy was to take advantage of temporary price differences between the SIMEX and OSE Nikkei 225 contracts.

So, If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX.

But Leeson was not short on SIMEX, infact he was long approximately the number of contracts he was supposed to be short.

These were unauthorised trades which he hid in an account named Error Account 88888.

He also used this account to execute all his unauthorised trades in Japanese Government Bond and Euroyen futures and Nikkei 225 options

OPTION CONTRACT

Straddles: Profitable (Premium) if Nikkei

traded within or near strikes between 18,500 – 20,000

January 17,1995 Violent earthquake hit Kobe,

Japan Nikkei fell 1,500 points

Leeson had sold 70, 892 Nikkei put and call options with a nominal value of $6.68 billion against the bank’s capital of $615 million

Leeson's Positions as at End February 1995

Number of contractsnominal value in US$ amounts

Actual position in terms of open interest of relevant contract

Reported Actual

Nikkei 225

30112$2809 million

long 61039$7000 million

49% of March 1995 contract and 24% of June 1995 contract.

JGB 15940$8980 million

short 28034$19650 million

85% of March 1995 contract and 88% of June 1995 contract.

Euroyen 601$26.5 million

short 6845$350 million

5% of June 1995 contract, 1% of September 1995 contract and 1% of December 1995 contract.

Adds up to MASSIVE MARGIN CALLS for Baring’s

How Leeson Broke Barings?

How did he do that?

Cross-trade technique with a real account “92000” and the error account “88888”

Year Reported (Million) Actual (Million)

1993 +£ 8.83 -£ 21

1994 +£ 28.53 -£ 185

1995 +£ 18.57 -£ 619

Result of Leeson’s Trading

The damage $1.4 billion dollars lost

Nick Leeson fled out of London Eventually caught by Interpol in Germany Sentenced 6 and ½ years of prison in Singapore

Case 2 : Amaranth Advisors L.L.C.

COMMODITY FUTURE SPREADS

Commodity Future Spread

Difference between the asking price and a bid on securities and financial instruments

Trader buys one contract and simultaneously sells another

Profit arises due to the difference between the prices

Different type of spreads intracommodity, intercommodity, calendar, etc

Spread Strategies

Buying the Spread: When an investor expects the price between two contracts to widen he buys the spread

Selling the Spread: When an investor expects the price to diminish he sells the spread

Example of Spreads

Buying a Spread – Sell the contract with lower price and buy the contract with higher price

Assuming no supply constraints March Wheat price - Rs 1350/Quintal May Wheat price - Rs 1375/Quintal Lot Size – 10 Quintals Initial Spread – Rs 25

As March approaches both the contracts rise but deferred contract rises faster to Rs 1360 and 1390 respectively

Loss in March contract – 10*10 = Rs (100) Profit in May contract – 15*10 = Rs 150 Net Profit – Rs 50

Example of Spreads

Selling the Spread – Selling the higher price contract and buying the lower priced

If both contracts fall

Sold contract falls more – Profit Bought contract falls more – Loss

More effective in case of seasonal crops

Introduction to the case

• Amaranth was a hedge fund operating in Connecticut since 2000

• In September of 2006, Amaranth lost $4.942B (about 48% of the fund value)

• The losses came from the energy trading desk headed by Brian Hunter

• Multi Strategy Hedge fund

Strategy Adopted

• Calendar Spread Trade betting WINTER beats NON-WINTER

• Long winter natural gas futures, options, swaps

• Short non-winter natural gas futures, options, swaps

Historical Returns for September

Risk Management at Amaranth

Risk Manager for each trading book

The risk group produced daily position and profit and loss(P&L) information, greek sensitivites ,leverage reports, concentrations, premium at risk,and industry exposures

All long and short positions were broken down and top 5 positions were listed

A liquidity report with positions and respective volumes for each strategy was used to constrain the size of each strategy

Why Strategy Failed

September prices fell due to storage glutHunter hoped for exponential profit if prices

reboundedMild winter and meek hurricane season

forced prices to fall moreThey were chasing a 4% return for a max

loss of 21% which in itself was very riskyOnly $3 billion might have been available

for margin calls on $53 Billion positions, leveraged 17.84 times ($53,524,979,537 /$3,000,000,000)

Case 3: Long Term Capital Management

Partners

John Meriwheter1974(joined Salomon Brothers) -> 1988(Vice

Chairman) -> 1994(founded Long Term Capital)

David Mullens1990(Vice chairman at Federal Reserve) ->

1994(Joined LTCM)

Robert Merton and Myron ScholesProfessors at eminent Universities and Noble

Laureates

Overview of the Fund

Traded on the good name of the members LTCM accumulated large capital despite the

high fees (2% of capital + 25 % of profits , other hedge funds 1

% of capital + 20% of profits)Hedge fund – minimum reporting

requirements to SECUnregulated, free to operate in any market

Overview of the fund

Ability to put on interest rate swaps at the market rate for no initial margin - an essential part of its strategy.

Ability to borrow 100% of the value of any top-grade collateral, and with that cash to buy more securities and post them as collateral for further borrowing.

LTCM first two years of operation – 43% and 41% ROE.

Some Facts

To increase ROC , increased leverage.

Played in the mortgage backed securities market.

Main Strategy: Find mispriced securities, and explore differences until the markets correct themselves.

Complex mathematical formulas developed by the traders in order to identify market abnormalities.

Variety of markets: US Treasury bonds, Danish mortgages, Russian bonds, mortgage bonds, Latin American bonds, UK bonds, US swaps, and US stocks.

Investment in emerging economies

LTCM's on balance sheet assets totalled around $125 billion, on a capital base of $4 billion, a leverage of about 30 times.

Leverage was increased tenfold by LTCM's off balance sheet business whose notional principal ran to around $1 trillion.

Downturn

In May and June 1998, a downturn in the mortgage-backed securities market led to a 16% loss in the value of equity

On August 17, 1998, Russia announced that it was restructuring its bond payments( defaulting on its debt)

By August, LTCM had lost 52% of its 1997 value

Most of LTCM's bets had been variations on the same theme, convergence between liquid treasuries

Unfortunately convergence turned into dramatic divergence.

The bailout

Investors lost 90% of their money in just two months. On September 23, NY Federal Reserve organized a bailout of

LTCM, encouraging 13 banks to invest $3.6 billion in return for a 90% stake in the firm.

In the end 11 banks put in $300 million each Rescued by Banks in their own interest and FED to avoid

systemic risk. LTCM continued operations, earning 10% in 1999 On July 6, 1999 LTCM repaid $300 million to its original

investors who had a residual stake in the fund of around 9%. Finally, liquidated in 2000

Reasons for disasters

Complex structures and relationships Increasing participation of inexperienced partiesOTC nature leading to unreported transactions.Very lucrative instruments, very high risk and hence

disasters happen.Opaque financial systems and disruptive information

flow.LEVERAGE In Illiquid MarketsBiases in the use of VARUnexpected correlation or the breakdown of historical

correlationsThe danger of over-generous extension of trading credit Use of complex mathematical models

Lessons To Learn

Liquidity Risk is a real risk that must be accounted for by both exchanges and hedge funds, money managers, or traders.

Transparency across exchanges in the same market may be useful

More standard measures ought to be devised ( as with VaR, traders, risk managers, regulators, and exchanges )

Internal risk management Spread positions can lose money and are not “arbitrage

positions”, Use of appropriate Mathematical Models Realistic assumptions & close watch on the market players. Control on Greed Close watch & Control on the Leveraged Position