Financial Derivative Case Studies Essay

INTRODUCTIONFinancial deriveds fix crept into the nations touristed economic vocabulary on a wave of recent promotional material about serious financial losings suffered by municipal governments, intimately-known corporations, strands and mutual funds that had invested in these products. Congress has held hearings on derived function instruments and financial commentators energize spoken at length on the topic. Derivatives, however remain a type of financial instrument that few of us understand and less 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 apply, they preserve provide outstanding benefit. If they are mishandled or misunderstood, the runs can be ruinous. Derivatives are not inherently bad. When there is full understanding of these instruments and responsible prudence of the put on the lines, financial derivatives can be useful tools in pursuing an enthronement schema.DERIVATIVESA derivative is a haveual relationship established by two (or to a greater extent) parties where earnings 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 unquestion fitting are limited only by the human imagination. Therefore, there is no definitive list of derivative products.Why Have Derivatives?Derivatives are attempt-shifting devices. Initially, they were used to reduce exposure to changes in foreign trade judge, engagement rates, or stock indexes. For example, if an American company expects containment for a shipment of goods in British Pound Sterling, it may enter into a derivative write out with an other(a) party to reduce the take chances that the replace rate with the U.S. dollar shaft will be more unfavorab le 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 danger of exchange rate movement to other party. more recently, derivatives have been used to segregate categories of investment risk that may entreaty to different investment strategies used by mutual fund managers, embodied 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 jibe an interest in a pool of residential home mortgages. virtuoso derivative product may provide that the purchaser receives only the interest payments made on the mortgages while another product may place that the purchaser receives only the pri ncipal 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 securities industrys increasingly have operate subject to greater swings in interest rate movements than in historic decades. As a result, financial derivatives have appealed to unified treasurers who wish to reward return of favorable interest rates in the steering of corporate debt without the expense of issuing newly debt securities. For example, if a corporation has issued long landmark 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 drifting interest rate, without disturbing the underlying principal amount of the debt itself.RISK INVOLE IN DERIVATIVESThere are four risk associated with derivatives.* Market risk* in operat ion(p) risk* Counter party accredit risk* Legal riskMarket riskThe risk to earnings from adverse movements in grocery store equipment casualtys.Operational riskThe risk of deprivationes occurring as a result of inadequate systems and control, human error, or counsel failure.Counter party credit riskThe 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 riskThe risk of loss because a contract is found not to be legitimately 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 strippingBarings PLC was the oldest merchant marge in Great Britain. Founded in 1762. With total shareowner equity of 440 million, it was far from t he titanicst 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 secures Singapore futures subsidiary had mixed-up huge sums of money speculating on Nikkei-225 stock index futures and survivals. In the days that followed, investigators found that the banks total losses exceeded US$1 billion, a sum bounteous enough to bankrupt the institution.STRATEGIES AND TRANSACTIONCONTEXTIn 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 remuneration were expected to come p rimarily from brokerage commissions for trades executed on behalf of customers and other Barings subsidiaries. Most of BFSs disdain 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 presidency 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 measure is based on the Nikkei-225 stock index, an index of the aggregate honour of the stocks of 225 of the full-grownst 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 grade is determined by changes in the three-month Euroyen deposit rate. A futures option is a contract that gives the corrupter the right, but not the obligation, to buy or change a futures contract at a stipu lated hurt on or in the lead some specified expiration particular date.STRATEGIESDuring 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 spread out including merchandise. Baringss circumspection understood that such trading involved trade in Nikkei-225 stock index futures and 10-year Japanese Government Bond (JGB) futures. both(prenominal) 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 trouble believed, he began placing bets on the direction of price movements on the Tokyo stock exchange. Leesons describe trading profits were spectacular. His earnings soon came to account for a hearty share of Barings total profits the banks senior worry regarded him as a star performer.After Barings failed, however, investigators found that Leesons describe prof its had been fictitious from the loot. By manipulating information on his trading activity, Leeson was able to hide his trading losses and report humongous profits instead. A major part of Leesons trading strategy involved the exchange of options on Nikkei-225 futures contracts. The vender of an option earns a premium in replica for accepting the obligation to buy or sell the underlying power point 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. erstwhile(prenominal) 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.TRANSACTIONLeesons trading losses from 1992 through the end of February 1995. By the end of 1992 entirely a few months after he had begun tradingLeeson 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. keep down cumulative losses at the end of 1994 stood at 208 million. That amount was moderately 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 besides 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 strike on January 17 when news of a violent earthquake in Kobe, Japan, sent the Japanese stock market into a tailspin. Over the coterminous five days, the Nikkei index fierce over 1,500 points Leesons options positions sustained a loss of 68 million. As stock prices fell, he began purchase coarse amounts of Nikk ei stock index futures. By February 6, the Japanese stock market had retrieve 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 dismount again making losses to multiply. Barings faced massive valuation account calls as Leesons losses mounted. While these margin calls raised eyebrows at the banks London and Tokyo offices, they did not prompt an immediate motion into Leesons activities. It was not until February 6 that Baringss group treasurer, Tony Hawes, flew to Singapore to examine 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 reprobate this miss of conversation 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 imputable to its desire to attract business.Events touch 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. steering failed at various levels and in a variety of waysWHAT LESSONS atomic number 18 TO BE LEARNED FROM THE CASE/ DISASTER?HIGHLIGHTED WEAKNESS(1) The lack o f communication between securities and futures exchanges and regulators in different countries, and (2) Conflicting laws on the legal attitude 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 complete 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.METALLGESELLSCHAFTMetallgesellschaft AG (hereafter, MG) is a large industrial conglomerate engaged in a grand rang e of activities, from mining and engineering to trade and financial services. In celestial latitude 1993, the firm reported huge derivatives-related losses at its U.S. anoint subsidiary, Metallgesellschaft ameliorate and Marketing (MGRM).STRATEGIES AND TRANSACTIONCONTEXTIn 1992, MGRM began implementing an aggressive marketing course of instruction in which it offered long-term price guarantees on deliveries of gasoline, heating embrocate, and diesel fuels for up to five or ten years. The first was a firm touch on chopine, 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 tractableness to set the delivery schedule.STRATEGYBy September 1993, MGRM had committed to sell forward the equivalent of over 150 million barrels of vegetable oil for delivery at fixed prices, with most contracts for terms of ten years. twain ty pes 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 in a higher place 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 spark the exposure resulting from its delivery commitments by buying a combination of short oil swaps and futures contracts as part of a strategy known as a stack-and-roll disconcert.TRANSACTIONIn its simplest form, a stack-and-roll put off 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 so the term stack-and-roll. MGRM implemented its hedge strategy by maintaining long positions i n a wide variety of contract months, which it shifted between contracts for different oil products (crude oil, gasoline, and heating oil) in a manner int terminate to minimize the be 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 equilibrate 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 have a go at it its futures trading losses immediately, triggering huge margin calls. Normal ly, 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(p) 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 course of theater of operations as of the same date.WHO WAS RESPONSIBLE FOR THE LOSS?MGs visiting card 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-te rm contracts with its customers. This action further complicated matters. The actions of MGs board of supervisors in this incident have spurred widespread study 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 auditory sensation 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 pass on 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 riskthe risk of loss caused by inadequate systems and control or management failurethan 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 CASESThe 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 proctor 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 managem ent has been faulted for being overly complacent in the face of a large number of warning signs. If these two disparate incidents offer any mavin lesson, it is the need for senior management to understand the nature of the firms activities and the risks that those activities involve.