Past articles: Derivative Misadventures

This article appeared in Corporate page of The Edge Malaysia, Issue 801, Apr 12 - 18, 2010


The Misadventures of Derivatives (Part 1)

By Jasvin Josen

"I think that derivative products... the CDS on sovereign debt have to be at least very, very regulated, rigorously regulated, limited or banned, this is a personal position on financial instruments," French Economy Minister Christine Lagarde told Europe 1 radio on Sunday, Feb 28, 2010. Her annoyance appears to be caused by speculators driving up European CDS spreads, which sets off sovereign bond investors to also demand significant yields, at the expense of the European public.

This is not the first time derivatives are being held responsible for mayhem in financial markets. This article delves into history, to look for other misadventures of derivatives, and tries to unearth any nuggets of wisdom they may offer for the future.

17th century: Futures and Options in the Tulip Mania

In 1593 a few Tulip bulbs from Turkey reached the Netherlands for research and cultivation. The rarity and exclusiveness of the flower attracted the attention of royalty and became a status symbol. The tulip was therefore not an ordinary flower and its price increased steadily.

Around 1630 these Tulip buds were attacked by a rare virus that ironically made spectacular patterns on the flower, making it even more attractive.

The rarity of the virus, the growing demand and the laborious process to cultivate this flower began to make the flower even more expensive. The demand for tulips grew quickly but the supply of bulbs did not. The tulip is not a simple flower to cultivate. The flower can be cultivated either from the bulb or the seed. While the tulip can produce two or three bulbs annually, these bulbs are exact clones of the mother bulb. Cultivating the most appealing varieties could take years; varieties or hybrids could only appear from planting the seeds which takes seven to twelve years to produce a flowering bulb.

• Tulip Forwards and Futures

Tulips bloom in April and May for only a week or two and the secondary bulbs appear shortly after. The bulbs can be uprooted and moved about from June to September. Actual purchases of bulbs (in the spot market) occurred during these months. During the rest of the year, traders signed contracts before a notary to purchase tulips at the end of the season. [Famous First Bubbles: The Fundamentals of Early Manias , Garber, Peter M. (2000)]

It is not clear if the contracts then should be referred to as forwards or futures in today’s terms. Historical sources state that neither party paid initial or variation margins and contracts were done with individual parties rather than with an exchange. However, traders did meet at taverns and purchasers of a futures contract paid a small amount upfront (say 2.5% of the agreed futures price) called “wine money” (broker’s commission in today’s terms). In any case, a forward and a future are both agreements where two parties agree on a price today for a good to be delivered in the future.

Forward contracts reduce the risk for both parties against fluctuations in price in the future. However this derivative also invites speculators who are neither end sellers nor buyers but just interested in price movements. The same contract would change hands several times as buyers and sellers closed out their positions before the delivery date in return for a better price. The entire market got over run over by speculators who kept on bidding the price higher and higher. These future contracts were derogatorily described as windhandel (meaning wind trade) because no bulbs were actually changing hands.

Soon everybody was dealing in tulip bulbs as speculators. Farmers were mortgaging their land and livestock to raise cash to begin trading.

Leveraged burgomasters (equivalent to town mayors today) were tied into paying above-market prices for bulbs to be delivered in the spring. But eventually the tulip market started to decline, spurred by an increase in supply from neighbouring countries. At a routine bulb auction, for the first time, no greater fool showed up to pay a higher price for future tulip contracts. Quickly after this there was a panic in which everyone started realising that tulips were not worth their prices. The tulip market evaporated.[source; Business Week, April 24, 2000, Mike Dash]

• Tulip Options

The Dutch burgomasters began losing money and had to do something to protect themselves. According to a view by Earl A. Thompson, an economist at the University of California, the burgomasters ultimately ironed out a deal with the authorities.

Without much delay, the authorities announced that all futures written after November 30, 1636 would be altered. The decree transformed the obligation into a just a right to buy the bulbs. In modern terminology, the futures had changed into options. If the market price fell, the buyer could opt out to pay a penalty (option premium) and forgo receipt of the bulbs rather than to pay the full contract price.

The contract price was now called the exercise (strike) price. If prices stayed high at maturity, the option buyer (or previous future buyer) would exercise the option, thus pay the exercise price and take delivery. But if the price was low, he could just cancel the contract, and the penalty (apparently at around 3% of the contract price) would go to the seller of the contract as compensation.

What followed then was a soaring of contract prices to reflect the expectation that the contract price was now a call-option exercise (strike) price, rather than a price committed to be paid for the future bulbs. Even before the formalisation of the conversion, the news was already filtering through the market. Buyers were already treating the contract prices as option strike prices set around 10 times the actual. Tulip planters would have to jerk up the contract prices significantly to recover sums.

So the market exploded. By February 1637, just three months after the announcement of the conversion, the price had apparently increased 20 times! In the three years of the Tulip commerce life cycle (1634-1637), the famous Tulip bulb reached a height of US$76,000!

No deliveries were ever made to fulfil these contracts as the market crashed in February 1637. When the mania was over, the price of tulip dropped from a high of US$76,000 to less than one dollar.

Conclusion

Interference in free market forces as a result of overnight conversion of tulip futures into options caused a serious backlash in the 17th century. Coming back to the 21st century and the European sovereign CDS problem, the 17th century burgomasters might advise not to hold on to the last straw to disallow speculation in sovereign CDS!

In the next article, we get to see futures and options causing mayhem in the 1990s.
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This article appeared in Capital page of The Edge Malaysia, Issue 802, Apr 19 - 25, 2010


The Misadventures of Derivatives: The 1990s

By Jasvin Josen

The last article enlightened us about the misadventure of futures and options that occurred far back in the 1630s with the Tulip craze. We now examine further derivative craftwork that led to the failing of some organisations in the 1990s.

1994: Inverse Floaters in Orange County

On Dec 6, 1994, Orange County, a district in southern California declared bankruptcy after suffering losses of around $1.6 billion from a wrong bet on interest rates in one of its investment pools. The Treasurer, Robert Citron used highly leveraged funds to go deeper and deeper into yield curve play strategies using interest rate derivatives.

The specific interest rate derivative was an inverse floater, a variation of an interest rate swap. A normal interest rate swap pays coupons of [LIBOR + x%] in return of a fixed rate of interest. An inverse floater pays a floating rate of [X% - LIBOR] in return for a fixed rate. Observe that with an inverse floater, the floating payment rises when the underlying floating rate (LIBOR) falls. When this happens, the price of the swap increases, as the price is simply the total present value of the floating payments minus the present value of the fixed payments.

The treasurer was betting that interest rates would not rise. From 1989 to 1993 the US interest rates were falling. He invested heavily in Invert Floaters and made some handsome profits during that period.

Another yield curve play was to borrow short term and lend long term. Orange County borrowed funds from the repo market. A repo market is a money market where borrowers get short term financing by pledging high quality securities. Part of the borrowed funds were lent back into the repo market, at the longer end (with higher interest rates). The collateral received from the money lent was pledged in the repo market again and the cash was used to buy more notes. This vicious circle went on until the county was loaded with $13 billion of debt. For a county with just over $7.5 billion of capital funds, the pool had over $20 billion worth of investments.

If short term interest rates had remained the same or declined, this strategy would have paid off. But the tactic soured with a shift in policy by the Federal Reserve in Feb 1994 implementing a succession of interest rate hikes. As interest rates climbed, the coupons from the Inverse Floaters fell and revenue decreased. The derivatives also plunged in value. Orange County was unable to honour loans in the repo market. This spooked local government investors, who pulled out immediately. Wall Street counterparties also started demanding billions of dollars of collateral. Orange County was caught in a liquidity trap it could not escape.

1995: Equity Index Futures and Straddle Options in Barings

Barings Banks, a 200 year old British bank went bankrupt in 1995 with losses close to $1 billion. All this from trading in equity futures and options by a single trader, Nick Leeson in its Singapore branch.

The trader’s mandate was to arbitrage (or switch) between Nikkei 225 futures in Singapore and Osaka. Such arbitrage involves buying futures contracts on one market and simultaneously selling them on another at higher price, whenever a price difference is spotted. Margins on arbitrage trading are minutely small since arbitrage trading is a very common activity in the market as everyone tries to take advantage of the price difference on a publicly traded futures contract. However, in arbitrage, one is buying something at one market while selling the same good at another market at the same time. Almost all risks are hedged and the strategy is not very risky.

However, instead of arbitraging, Leeson made directional bets (i.e. without hedging) in the Japanese future markets, using equity index futures and options. Compared to arbitrage trading where the returns were small (and safe), this strategy was very lucrative (and risky).

An equity index or stock index tracks changes in the value of a hypothetical portfolio of stocks. An equity index future is an agreement between a party and the futures exchange to buy and sell the index of the stock exchange at a certain time in future, at an agreed price. For example, A can go long (buy) the Nikkei 225 at 10995 that expires in June 2010. Come expiry, if the actual index stands at 11100, A would have made a profit of 105 (11100-10995). The principle is not very different from the Tulip forward in the previous article, just with the underlying being an equity index. Index futures contracts are always cash settled as there is nothing to 'actually buy or sell' in case of an index. You simply pretend that you are buying the 'index' and cash settle it at the expiry date. Leeson was long the Nikkei 225 equity index futures.

Nick also sold options, specifically straddles. A straddle is a call and a put at the same strike price and the same expiry. For example, dealer X writes (sell) straddles on Nikkei 225 with a strike price of 10995 that expire in Sep 2010. Dealer X is actually selling a call and a put simultaneously. As he is the seller, X receives premiums on both the call and the put. If the index goes up, X suffers a loss. If the index goes down, X also suffers a loss. This strategy makes money for the dealer when the market remains stable. Any losses from the call or put are expected to be small and less than the premiums received at the inception of the straddle. Chart 1 helps us to visualise this trade through a profit and loss diagram.

Chart 1
Nonetheless, danger looms as soon as the market turns volatile. The dealer loses money when the index moves up or down in large momentums. Worse, as the writer (seller) of the option, his loss is unlimited. This is what happened to Leeson in the Barings case. Luck ran out when the Kobe earthquake sent the Asian financial markets into a tailspin and sent the Nikkei plunging. Leeson’s bet on a rapid and stable recovery by the Nikkei failed to materialise.

As losses mauled, it is said that Leeson bought even more Nikkei futures (hoping that the Nikkei will make a quick corrective come back) and sold Japanese Government bond futures betting that Japanese interest rates will rise. They turned on him again with massive margin calls that the bank could not sustain.

Sources also state that Leeson did not keep the trades delta-neutral in order to avoid first order risk at the very minimum. In other words, he did not hedge his bet (perhaps with long straddles or futures) against the most obvious risk, the underlying index move.

Conclusion

Orange County declared bankruptcy allegedly due to derivatives trading but more precisely due to the use of leverage in a portfolio of short term Treasury securities. As for Barings, an employee with a mandate to hedge or to look for arbitrage opportunities turned into a speculator.

Countless measures and regulations are put in place all over the globe to guard against future mishaps that may well be caused by derivatives. Important areas include risk management, credit risk, liquidity risk, internal controls, model testing, ...the list goes on.

But more importantly, we need to accept that mankind has created a very versatile financial instrument which is here to stay. And as with anything else, flexibility allows one to bend towards good or mischief.

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