DERIVATIVE DISASTERS

Some well known disasters have resulted in derivatives getting a bad name in the public imagination. There are some lessons to be learnt from these disasters so that the benefits of derivatives can be obtained without exposing the company to such risks. When a trader incurs a loss, he is often tempted to cover it up and hope that the loss will be recouped in the coming days. Traders who are more aggressive, adopt a doubling strategy to accomplish this.

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Doubling is a gambling strategy. A gambler who looses 1000/- in the first round, stakes 2000/- in the second round, so that if he wins, he recoups the past loss and makes a profit at the same time. If he looses again, he stakes 4000/- in the third round, so that if he wins he recoups the past loss of (1000 + 2000) and makes a profit of 1000/-. Again, if he looses he stakes 8000/- so that if he wins, he recoups past loss of 7000/- and gains 1000/-. The game is played in this way in a hope that bad luck cannot stay for ever and whenever he wins, he makes full use of the opportunity.

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The risk entailed is that he may be wiped out completely before his good luck appears. For this reason, prudent gamblers do not use doubling strategy. They prefer to accept an initial loss of 1000/- and continue the game at a modest level and avoid bankruptcy. Banks and financial institutions have strict internal rules on the size of the position that they can take. They even thrust such restrictions on their important clients.

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There are however, some smart traders who seek to bypass these rules. They hide their trades or misrepresent the risks involved, so that the senior management does not realize what is happening. By the time it is found out it is too late. Nick Leeson & Barrings Bank : Leeson told his superiors that he was carrying out arbitrage between the bank and Nickei futures traded in Osaka & Singapore. He initially made huge profits for the bank by exploiting narrow price difference between the two exchanges on the same derivative contract.

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After a point of time, he started making huge losses, to recoup which he adopted the doubling strategy. What his superiors did not realise was that Nick Leeson had created an account numbered 88888 as an error account . Leeson had ensured that the MIS reports generated out of the software did not show the balance in the error account to any one of the top management of the bank. As he continued to loose money, the positions became so large that they could no longer be sustained.

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The episode ended in a loss of $1.4 billion and caused Barrings Bank to go bankrupt. Lessons to learn : 1. Need of adequate internal control system before dealing in derivatives. 2. There is immense liquidity in the derivatives market which allures one to take large positions. Ultimate positions should be predefined with respect to the loss bearing capacity of the organization.

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3. The derivatives market provides huge leverage. Large positions can be adopted by using relatively very small amount of cash. Hence, the initial cash outflows do not draw attention till the point it starts making a loss. 4. The derivative markets are complex which makes it easier for smart executives to fool their superiors, specially when those superiors do not have any practical exposure and knowledge of derivatives.

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MG refining & marketing (MGRM) : was a US subsidiary of a large German conglomerate Metallgesselschaft. MGRM as engaged in a variety of business related to oil exploration, refining, storage and transport. In the early 1993 oil prices had declined below $20 per barrel. MGRM saw a business opportunity in selling long term oil contracts to corporations who wanted to lock in the low prices. MGRM sold 10 year contracts totaling to 16 crore barrels of crude and hedged the risk by buying an equal amount of short term crude oil futures.

DERIVATIVE DISASTERS
Towards the end of 1993, crude prices fell below $15. At this point MGRM was sitting on huge profits because its customers were committed to pay @ $20, when it was worth below $15. Because of the hedged position the company was also accumulating losses at the same time. Ideally, the loss from futures hedge should have been set off by the gain from the gain of the long term selling contracts. THAT WAS THE FUNCTION OF HEDGING.

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However, the losses in the short term future contracts had to be paid out in cash in the short term while the profits arising out of long term selling contracts would accrue over the next 10 years. This demanded huge liquid funds, which caused the German parent firm to panic. The parent companys management was worried and the entire business model was flawed. Decision was taken to absorb the current estimated loss and stop any further derivative trading.

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Lessons to be learnt :

1. MGRM did not decide on the crucial issue of hedge quantity in the optimal way. (Optimal hedge ratio). 2. They did not realize that this kind of business model required large reserves of dedicated liquid money. 3. MGRM before adopting the business model should have arranged for the finance of liquid money either from the parent firm or some other financial institution.