Chapter 1: Primer on Derivatives 1 What Are Derivatives? 1 Who Buys and Sells Derivatives? 2 Where Are Derivative Contracts Bought and Sold? 2 Two Major Types of Derivatives 3 Forward Contracts 3 Option Contracts 4 Forward Contracts 4 Long Forward in Action 5 Short Forward in Action 6 Options 7 Call Options 7 Put Options 8 American versus European Options 9 Examples of Puts and Calls in Action 9 4,000 Years of Derivatives 13 Conclusion 14 Risk Notepad 1.1: OTC-traded versus Exchange-Traded Derivatives 15 Review Questions 18 Bibliography 19 Chapter 2: Employee Stock OptionsA Users Guide 21 ESOs: A Major Pillar of Executive Compensation 21 Why Do Companies Use ESOs? 22 Aligning Incentives 22 Hiring and Retention 23 Adjusting Compensation to Employee Risk Tolerance Levels 24 Employee Tax Optimization 24 Cash Flow Optimization 25 Option Valuation Differences and Human Resource Management 26 Problems with ESOs 37 Employee Motivation 38 Improving Performance 40 Absolute Versus Relative Performance 40 Possible Solutions to Employee Stock Option Problems 41 Premium-Priced Stock Options 41 Index Options 42 Restricted Shares 45 Omnibus Plans 45 Conclusion 46 Review Questions 46 Bibliography 47 Chapter 3: Metallgesellschaft AG Illusion of Profits and Losses, Reality of Cash Flows 51 Metallgesellschaft: Evolution of the Company and Its Product Lines 51 Energy Derivatives at MGRM 52 Energy Markets on a Roller Coaster 53 Risk Notepad 3.1: What Is the Difference Between Contango and Backwardation? 55 MGRMS Innovative Energy Derivative Products 56 MGRMs Embedded Options 58 Hedging MGRMs Forward Energy Exposures 59 Payoff Profile of a Short Forward Position 59 The Ideal Hedge Was Not Available 61 Physical Storage Hedge 61 Stack-and-Roll Hedge 62 Cash Flow Effects of a Stack-and-Roll Hedge 64 Scenario #1: The Price of Oil Falls and Basis Falls for Two Consecutive Months 65 Stack-and-Roll Hedge Ratios 69 MG Calls It Quits 69 MGRM Butts Heads with NYMEX and the CFTC 70 MGRMS Profitability: Its All in How You Account for It 71 MGRMS Credit Rating 72 The Effects of an Itchy Trigger Finger 72 Was MGRM Hedging or Speculating? 72 Corporate Governance Issues 73 Conclusion 74 Review Questions 75 Bibliography 76 Chapter 4: Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust 77 P&Gs Motivation for the Swaps 78 Motives for the U.S. DollarDenominated Interest Rate Swap 79 Motives for the German MarkDenominated Interest Rate Swap 80 Motives for Using the Over-the-Counter Market 80 The U.S. DollarDenominated Swap 81 Plain Vanilla Swap 82 P&Gs Gamble: The Speculative Side-Bet 83 Viewing P&Gs Speculative Side-Bet as a Short Call Option 84 Risk Notepad 4.1: Security Yield versus Price 86 The Effect of Rising U.S. Interest Rates 87 Losses on P&Gs U.S. Dollar Interest Rate Swap 91 German Mark-Denominated Interest Rate Swap 93 The Suit against Bankers Trust 95 Risk Notepad 4.2: Value at Risk 97 The P&G-BT Settlement 98 How Did BT Fare After the Swaps? 98 P&G-BT from an Investors Perspective 99 The Landmark P&G-BT Court Opinion 100 Major Legal Issues 100 An Unusual Court Opinion 101 Summary of the Court Opinion 102 Disclosure Reform after P&G-BT 102 Should Corporate Treasuries Be Profit Centers? 103 Conclusion 103 Review Questions 104 Bibliography 105 Appendix 4.1: What Is an Interest Rate Swap? 107 Chapter 5: Orange CountyThe Largest Municipal Failure in U.S. History 109 Robert Citron and the Orange County Board of Supervisors 109 The Orange County Investment Pool 112 The Major Risks Facing Assets in the OCIP Portfolio 114 Credit Risk 115 Market Risk 115 Liquidity Risk 116 OCIPs Assets and Funding Sources 117 Structured Notes 118 Risk Notepad 5.1: Other Assets in the OCIP Portfolio 118 Fixed-Income Securities 120 OCIPs Funding Sources 120 Leveraging the OCIP Portfolio 123 Effects of Leverage on OCIPs Return 124 OCIPs Rising Returns: Effects of Falling Interest Rates 124 OCIPs Return Stabilizes: 1993 126 OCIPs Returns Plummet: 1994?Effects of Rising Interest Rates 127 The Consequences 128 Market Risk Causes Liquidity Risk 129 Government Paralysis 130 Citron Resigns 130 Lack of Liquidity Leads to Bankruptcy 130 Fire Sale of the OCIP Portfolio 131 Monday-Morning Quarterbacking 131 Was Orange County Truly a Derivative-Related Failure? 131 Was Orange County Really Bankrupt? 133 Was It a Mistake to Liquidate the OCIP Portfolio? 134 Could the Debacle Have Been Predicted? 135 Sentences, Blame, and Reform 136 Robert Citron 136 Other Players: Matthew Raabe and Merrill Lynch 137 Stealth Supervision: Shared Blame 138 Governance Reforms 139 Lessons Learned from Orange County 139 Safety, Liquidity, and High Yield Are an Impossible Combination 139 If You Cant Explain It, Then Dont Do It 140 Conclusion 141 Review Questions 141 Bibliography 142 Chapter 6: Barings Bank PLCLeesons Lessons 143 Barings Bank PLC 143 Nick Leeson: From London to Jakarta to Singapore 144 What Was Leeson Supposed to Be Doing at BFS? 145 Risk Notepad 6.1: What Are Stock Indices and Stock Index Futures Contracts? 147 Five Eights Account 148 Risk Notepad 6.2: Errors Accounts 149 Leesons Trading Strategy: Doubling 150 Risk Notepad 6.3: Doubling 152 Funding Margin Calls 153 Funding Source #1: Increasing Commission Income by Offering Deals at Non-Market Prices 153 Funding Source #2: Using the Financial Resources of Barings as His Cash Cow 154 Funding Source #3: Booking Fictitious Trades and Falsifying Records 155 Funding Source #4: Selling Options 156 Risk Notepad 6.4: Leesons Most Flagrant Falsification Scheme 156 Net Profit/Loss Profile of Leesons Exposures 157 Leesons Long Futures Positions 157 Leesons Short Straddles 159 Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract 161 Profit/Loss Profile: Combining a Long Futures Position and "Numerous" Short Straddles 162 Massive Purchases of Nikkei 225 Futures Contracts 163 Beyond Irony: The Barings Failure in a Broader Time Frame 164 A Bank for a Pound 165 Aftermath of the Barings Failure 167 How Could Barings Have Caught Leeson Sooner? 168 Conclusions 171 Review Questions 172 Bibliography 173 Chapter 7: Long-Term Capital Mismanagement"JM and the Arb Boys" 175 Risk Notepad 7.1: What Is a Hedge Fund? 176 LTCM: The Company 177 The LTCM Business 177 The Principals 177 LTCMS Strategy 179 Identifying Small Market Imperfections 179 Using a Minimum of Equity Capital 180 Securing Long-Term Funding 184 Charging Hefty Fees 186 LTCMS Impressive Performance: 19941997 186 LTCMS Contributions to Efficient Markets 189 Why and How LTCM Failed 190 Catalyst #1: Exogenous Macroeconomic Shocks 190 Risk Notepad 7.2: What Is Contagion? 192 Catalyst #2: Endogenous Shocks 193 The Fed, Warren Buffett, and the Rescue of LTCM 198 Risk Notepad 7.3: Another Look at Warren Buffetts Offer for LTCM 200 Conclusions and Lessons 202 Be Careful What You Wish For 203 Beware of Model Risk 203 All for One and "1" for All 203 Leverage Is a Fair-Weather Friend 204 Financial Transparency Is the First Step in Meaningful Reform 204 In the Long Run, Bet on Global Financial Market Efficiency 205 You Cant Float Without Liquidity 205 Some Things Are Worth Doing for the Greater Good 205 Epilogue 206 What Happened to the Principals, Creditors, Investors, and Consortium? 206 The Principals and Employees 206 Creditors and Investors 207 The Consortium 207 Review Questions 208 Bibliography 208 Appendix 7.1: Primer on LTCMs Major Trades and Financial Instruments 210 Appendix 7.2: UBS and the LTCM Warrant Deal 213 Chapter 8: Amaranth Advisors LLCUsing Natural Gas Derivatives to Bet on the Weather 217 Amaranth Advisors LLC 217 Natural Gas Markets 219 Amaranths Natural Gas Trading Strategy and Performance: 20052006 222 2005: Using Long Calls to Bet on the Weather 222 2006: Using Futures and Spreads to Bet on the Weather 223 Risk Notepad 8.1: Measuring Natural Gas and Putting Amaranths Positions into Perspective 227 Risk Notepad 8.2: Primer on Spread Trades 228 What Caused Amaranths Catastrophic Losses? 234 Inadequate Risk Management Practices 234 Lack of Liquidity 236 Extraordinarily Large Movements in Market Prices 238 Explosion or Implosion? Who Got Hurt? 238 Questions Remaining After Amaranths Fall 240 Did the Futures Markets Function Effectively? 240 Did Amaranth Dominate the Natural Gas Futures Markets? 240 Did Amaranth Engage in Excessive Speculation? 243 Did Amaranth Commit Regulatory Arbitrage? 244 Did Amaranth Manipulate the Price of Natural Gas? 245 Risk Notepad 8.3: A Tale of Two Hedge Funds 248 Conclusion 254 Review Questions 255 Bibliography 256 Chapter 9: Societe Generale and Rogue Trader Jerome Kerviel 259 Societe Generale (SocGen) 259 Jerome Kerviel (JK) 259 Back, Middle, and Front Office Jobs at SocGen 260 Arbitraging Turbo Warrants 261 What Are Plain Calls and Puts? 261 What Are Turbo Warrants? 262 How JK Built His Mountainous Positions 265 2005 265 2006 266 2007 267 2008 269 JKs Fraudulent Methods 269 Gaining Unauthorized Access to SocGens Computer Systems 270 Using Contract Cancellations and Modifications to Mask Positions and Risks 270 Entering Pairs of Offsetting Trades at Artificial Prices 271 Posting Intra-monthly "Provisions" 271 Navigating SocGens Dysfunctional Risk Management System 271 Exploiting Supervisor Turnover 273 How JK Was Caught 274 Paying the Piper 275 Did SocGen Know about JKs Fictitious Trades? 276 Network Incentives: Why Did JK Go Undetected for So Long? 278 SocGens Bonus Incentives 279 Doubling Strategies, Prospect Theory, and Survival Theory 280 Prospect and Survival Theory 281 SocGens Risk Management Reforms 282 Conclusion 283 Review Questions 284 Bibliography 284 Chapter 10: AIG: Two Roads to Ruin AIG: The Company 288 AIG-INV 289 AIGFP 289 Securitization: MBS, ABS, CDOs, and MBOs 290 AIGFPs Credit Derivative Portfolios 292 Major Keys to AIGFPs Initial Success 294 AIGs Chief Regulators 294 What Went Wrong? 295 AIGs Credit Protection Exposures 296 The Sources of AIGFPs Liquidity Problems 298 Securities Lending at AIG 301 AIGs Risky Securities Lending Operations 304 AIGs Bailout 306 What If AIG Was Allowed to Fail? 310 Regulatory Capital Risks 310 AIGs Insurance Affiliates Risks 311 Contagion Risks 311 Criticisms of the AIG Bailout 312 Postscript 313 Conclusion 314 Review Questions 316 Bibliography 316 Appendix 10.1: Primer on Credit Derivatives 318 Risk Notepad 10.1.1: The Long and Short of Credit Derivative Lingo 318 Chapter 11: JPMorgan Chase and the "London Whale" 323 JPMorgan & Company, the CIO, and the SCP 324 JPM and JPM Bank 324 The CIO 325 The SCP 326 The SCP Time Line 327 Risk Notepad 11.1: What Are Risk-Weighted Assets? 329 Risk Notepad 11.2: What Are the Basel Accords? 330 What Went Wrong at the SCP? 330 Mistake #1: Ignoring the SCPs Strategic Purpose 331 Mistake #2: A Failed Trading Strategy 332 Mistake #3: Disregarding JPM Banks Internal and External Risk Measures 336 Risk Notepad 11.3: The SCPs Five Major Risk Measures 337 Risk Notepad 11.4: Basel II.5 Accords Four New Risk Measures 338 Mistake #4: Manipulating JPM Banks Risk Metrics 339 Mistake #5: Publicly Misrepresenting the SCPs Financial Condition 341 Risk Notepad 11.5: What Is the Volcker Rule? 341 Dysfunctional Regulation 342 Conclusion 343 Aftermath 344 Risk Notepad 11.6: Aftermath 345 Review Questions 346 Bibliography 346 Appendix 11.1: Alphabetical List of the Main "London Whale" Decision Makers and Players 347 Appendix 11.2: Markit Group Limited 348 Risk Notepad A 11.2.1: A Rosetta Stone for Understanding Markit Groups Credit Indices and Abbreviations 348 Index 351
