Preface
The third edition of Risk Takers: Uses and Abuses of Financial Derivatives follows the precedent set by the second edition, with chapters focusing on the abuses of financial derivatives continuing to displace those explaining their beneficial uses. Yes, there is solace in knowing the same is true of financial stories we read and hear about every day. After all, when was the last time the news focused on a company using derivative instruments to stabilize revenues and costs, provide more job security to its employees, increase chances for continuous debt repayment, enhance shareholders’ long-term returns, or provide management with good-nights’ rest, knowing they were able to transfer to others risks that they were either unwilling or unable to bear themselves? My guess is you have seldom, if ever, read such stories or heard them reported on the evening news. Nevertheless, these good derivative uses occur every day and their gains far offset losses from reckless and unlawful uses.
Famous derivative fiascos, such as the ones explained in this book, rarely occur, but when they do, it is human nature to be interested in the how, who, and when surrounding them. Generically, there are two types of fiasco narratives. The first, which is the one I find more interesting, focuses on derivative losses caused by failed strategies. The second focuses on derivative losses caused by individuals who committed fraud, deception, and deceit.
In either case, it’s personal for me because the ages of individuals behind many of these stories were about the same as my students are now. I like to think that the wrongdoers were, basically, good people who just made very bad, out-of-character decisions for a short period of their lives. The problem was (and continues to be) that large derivative risks and losses can accumulate so quickly that it becomes virtually impossible to reverse them. As you might expect, the derivative perpetrators identified in this book were fired, but their acts also destroyed future job prospects, irreparably tarnished once-stellar reputations, and ruined personal relationships; some went to jail. As you go through this book, ask yourself one simple question: “If you were responsible for any of these famous financial fiascos, what would you pay to put your job, employment prospects, reputation, and personal relationships back the way they were?” Making a poor decision is a bit like grabbing onto a rope hanging from a rising hot air balloon. If you don’t let go immediately, you can’t let go at all.
A second precedent that Risk Takers’ third edition follows is providing readers with more examples, insights, and background information on derivative instruments. Where possible, I have also tried to offer a broader picture of the financial controversies and characters involved in these unfortunate episodes.
Purpose of the Book
I wrote Risk Takers as a practical supplement to the Risk Management course that I teach at Babson College in Babson Park, Massachusetts. This book is not a substitute for the rigorous mathematical and empirical information needed to understand the theoretical backbone of finance or the intricacies of derivative valuation. My goal is more modest, aiming to write an accessible book that helps bridge the gap between theory and practice. Based on my experiences, there are already excellent textbooks that focus on derivative instruments and risk-management techniques, but they are often technical, equation-heavy, and presume considerable knowledge of finance. As a result, their strength in rigor is a weakness in terms of accessibility. I have tried to make the analyses in this book understandable to readers at all levels. The real-life events discussed here provide a contextual framework for understanding and evaluating the potential risks and returns of derivative instruments. In those situations where support might be needed to understand a derivative instrument, I have tried to provide it in a user-friendly way.
These are not traditional case studies that provide brief descriptions of situations or problems and then set the stage for group discussions about possible solutions and approaches. Rather, the chapters thoroughly describe the strategies and events that affected companies and municipalities faced with derivative-related decisions. Companies have many risks to manage; the ones most prominent in this book are related to changes in market prices, liquidity, creditworthiness, and business environments.
Organization of the Book
Chapter 1: Primer on Derivatives is for readers with no background in financial derivatives and those whose memories might be a bit rusty. Chapter 2 focuses on the benefits and costs of employee stock options (ESOs). It explains why companies use this type of compensation and goes on to provide practical advice for anyone negotiating an employment contract offering ESO compensation. This chapter explains why employees should value ESOs quite differently from their employers.
The remaining chapters cover, in chronological order, companies that have been commonly associated with the “rogues’ gallery” of financial derivative disasters. Chapter 3 analyzes Metallgesellschaft AG, a German company that reported losses of $1.3 billion in 1993, due to mistakes associated with its sales of energy derivative contracts. Chapter 4 looks, in detail, at two interest-rate swaps between Procter and Gamble (P&G) and Bankers Trust, which were transacted in 1993 and 1994 and resulted in P&G losing $157 million. While these losses may seem small relative to those of other companies covered in this book, they led to landmark court decisions in financial security law. Chapter 5 probes the investment strategy and events that caused Orange County, California to lose $1.6 billion, in 1994, thereby earning it the ignoble reputation as the largest municipal failure in U.S. history.
Chapter 6 considers the speculative trades of Nick Leeson, a middle-level bank manager at Barings Bank’s Singapore branch, who, in 1995, lost $1.3 billion, resulting in the bankruptcy of the oldest and most prestigious merchant bank in England. Chapter 7 explores Long-Term Capital Management, the strategy it used to build a risk-neutral portfolio, and the chain of events, in 1998, that caused this premier financial institution to lose $4.5 billion in about two months. Chapter 8 investigates the 2007 demise of Amaranth Advisors LLC, which was the largest hedge fund failure in history – and maybe the quickest.
Chapter 9 examines Société Générale and how it lost €4.9 billion ($7.2 billion), in 2008, due to acts of fraud, deception, and excessive, one-sided equity index positions taken by Jérôme Kerviel, a junior trader working at the bank’s Paris-based Delta One unit. Chapter 10 dissects two strategic mistakes made by AIG, in 2008, which ended in a series of bailout packages that cost the U.S. government and Federal Reserve $182.5 billion. One mistake was in its sales of credit default swaps (CDS) and the other was its securities lending operations. Finally, Chapter 11 explains how, in 2012, the CDS positions of JPMorgan Chase’s Synthetic Credit Portfolio (SCP) caused losses amounting to $6.2 billion. The size of these losses was astonishing because the SCP was a relatively obscure, and seemingly innocuous, London-based operation that was supposed to be focusing on low-risk arbitrage transactions.
What Is New in the Third Edition?
In the third edition of Risk Takers: Uses and Abuses of Financial Derivatives, I have updated the chapters, deleted one (Chapter 3: Roche Holding: The Company, Its Financial Strategy, and Bull Spread Warrants), and added three new chapters, which focus on derivative debacles at Société Générale, AIG, and JPMorgan Chase. The chapter I dropped, on Swiss-based Roche Holding, was aging. Saying “Good bye” was difficult because it provided readers with an excellent example of a talented and courageous CFO’s ability to finance a world-class pharmaceutical company with an iconoclastic financial strategy, using financial derivatives as part of his approach.
As was the case with the second edition, I have made strong efforts to stick to the story, by relegating technical points to vignette sections, called “Risk Notepads.” I removed the online appendices, which were included in the first and second editions.
Resource and Learning Material
To motivate discussion and thoughtful reflection, I have provided end-of-chapter questions to test readers’ understanding of the major principles in the text.