Professional Documents
Culture Documents
Derivatives
A security whose price is dependent upon or derived from one or more underlying assets.
Contract between two or more parties. Value derived from the underlying assets. Underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes etc. High leverage Product.
Example
Person who comes with this paper can purchase a Peter England shirt at Rs.400 on or before 31st March, 12
Comes with the paper, Predetermined asset, Predetermined maturity, Predetermined rate,
Question - Answer
Price of that shirt is Rs. 500 If price changes from 500 to 700 ? If price changes from 500 to 400 ? If price comes to 300 ? If price comes to 100 ? If price comes to 1000 ? If asset does not exist ?
600
Value of Paper
400
200
0 0 -200 100 200 300 400 500 600 700 800 900 1000 1100
-400
Call Option
An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. Buyer of Call ----- Bullish View Seller of Call ----- Bearish View
Example
Mr. X Purchases the 3000 Nifty Feb 09 Call Option at Rs.100.
If Price goes up. The value of call option will go up If Price goes down. The value of call option will go down If Price remains constant the value of call option will come down
Question - Answer
Calculate the Value of Call option if Nifty Spot Price is
3100 3200 3500 3000 2950 2900 2500 3050 3025
P a y o ff o f C a ll O p tio n
600 500 400 Profit / (Loss) 300 200 100 0 -2 0 0 2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500 P ric e o f N i fty -1 0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500
-100 -100 -100 -100 -100 -100 -100 -50 0 50 100 150 200 250 300 350 400
Example
Mr. Y has sold the 3000 Nifty Feb 09 Call Option at Rs.100.
If Price goes up. The value of call option will go up If Price goes down. The value of call option will go down If Price remains constant the value of call option will come down
P a y O f f o f C a ll O p t io n
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500 0 0 0 0 0 0 0 50 100 150 200 250 300 350 400 450 500 100 100 100 100 100 100 100 50 0 -50 -100 -150 -200 -250 -300 -350 -400
600 400 200 Profit / (Loss) 0 2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500 P r i c e o f N i fty -2 0 0 -4 0 0 -6 0 0
Date
Price 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb
Change 100.20 98.18 96.11 94.00 91.84 89.63 87.36 85.03 82.64 80.17 77.63 74.99 72.27 69.43 66.48 63.38 60.13 56.69 53.03 49.10 44.82 40.09 34.72 28.35 20.05 0.00 -2.02 -2.07 -2.11 -2.16 -2.21 -2.27 -2.33 -2.39 -2.47 -2.54 -2.63 -2.73 -2.83 -2.96 -3.09 -3.25 -3.44 -3.66 -3.93 -4.28 -4.73 -5.37 -6.37 -8.30 -20.05
Impact of Time
Price of Option comes down as the time passes. Speed of Price reduction increases as the maturity comes nearer. Here price of call was Rs.100 on 1st of the month Which comes to Rs.87 after one week, Then it comes to Rs.66 after 15 days And finally it came to 0 on maturity
7-Feb 8-Feb 9-Feb 10-Feb 11-Feb 12-Feb 13-Feb 14-Feb 15-Feb 16-Feb 17-Feb 18-Feb 19-Feb 20-Feb 21-Feb 22-Feb 23-Feb 24-Feb 25-Feb 26-Feb
Price and Change 120.00 100.00 80.00 60.00 40.00 20.00 0.00
Impact of Time
Date
2/ 1/ 2 2/ 00 9 3/ 2 2/ 00 9 5/ 2 2/ 00 9 7/ 2 2/ 00 9 9/ 2/ 200 11 9 / 2/ 20 0 13 9 / 2/ 20 0 15 9 / 2/ 20 0 17 9 / 2/ 20 0 19 9 / 2/ 20 0 21 9 / 2/ 20 0 23 9 / 2/ 20 0 25 9 /2 00 9
0.00
-5.00
-25.00
-20.00
-15.00
-10.00
Put Option
An agreement that gives an investor the right (but not the obligation) to Sell a stock, bond, commodity, or other instrument at a specified price within a specific time period. Buyer of Put ----- Bearish View Seller of Put ----- Bullish View
Example
Mr. X Purchases the 3000 Nifty Feb 09 Put Option at Rs.100.
If Price goes down. The value of Put option will go up If Price goes up. The value of Put option will go down If Price remains constant the value of Put option will come down
Question - Answer
Calculate the Value of Put option if Nifty Spot Price is
2900 2500 2800 2000 3100 3200 3500 3000 2950
P a y o f f o f P u t O p tio n
350 300 250 200 150 100 50 0 -5 0 -1 0 0 -1 5 0
Profit / (Loss)
2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500 P ri c e o f N i fty
Example
Mr. Y has sold the 3000 Nifty Feb 09 Put Option at Rs.100.
If Price goes up. The value of Put option will come down If Price goes down. The value of Put option will go up If Price remains constant the value of Put option will come down
P a y O ff o f P u t O p tio n
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500 300 250 200 150 100 50 0 0 0 0 0 0 0 0 0 0 0 -200 -150 -100 -50 0
400 300 200 Profit / (Loss) 100 0 2700 2750 2800 2850 2900 2950 3000 3050 3100 3150 3200 3250 3300 3350 3400 3450 3500 P ric e o f N ifty -1 0 0 -2 0 0 -3 0 0
50 100 100 100 100 100 100 100 100 100 100 100
Types of Option
As per Maturity
Current Month Option Next Month Option Far Month Option
Intrinsic Value
The intrinsic value of an option is the amount an option holder can realise by excercising the option immediately. Intrinsic value is always positive or zero. An out of the money & at the money option has zero intrinsic value. Intrinsic value of In the money call option = underlying product price strike price. Intrinsic value of In the money put option = strike price underlying product price.
Bullish Strategies
Buy Lower Strike Call Option & Sell Higher Strike Call Option Buy Lower Strike Put Option & Sell Higher Strike Put Option Buy one Future and One ATM Put and Sell one OTM Call
Purchase 2500 March Call option at Rs.100 and Sell 2700 March Call option at Rs.50
Events Price Of Nifty Value of I Option Value of II Option Profit / (Loss)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000
-100 -100 -100 -100 -100 -100 -100 -50 0 50 100 150 200 250 300 350 400
-50 -50 -50 -50 -50 -50 -50 0 50 100 150 150 150 150 150 150 150
P a y o f f o f B u ll C a ll S p r e a d
500 400 300 200 Profit / (Loss) 100 0 -1 0 0 -2 0 0 -3 0 0 P ri c e o f N ifty
220 2250 2300 0 235 2400 2450 2500 0 255 2600 2650 0 270 2750 2800 2850 0 290 2950 3000 0
Bearish Strategies
Buy Higher Strike Call Option & Sell Lower Strike Call Option Buy Higher Strike Put Option & Sell Lower Strike Put Option
Purchase 2700 March Put option at Rs.100 and Sell 2500 March Put option at Rs.50
Events Price Of Nifty Value of I Value of II Profit / Option Option (Loss) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000 400 350 300 250 200 150 100 50 0 -50 -100 -100 -100 -100 -100 -100 -100 -250 -200 -150 -100 -50 0 50 50 50 50 50 50 50 50 50 50 50 150 150 150 150 150 150 150 100
P a y o ff o f B e a r P u t S p re a d
500 400 300 200 Profit / (Loss) 100 0 -2 0 0 -3 0 0 P r i c e o f N i fty
22 00 22 50 23 00 23 50 24 00 24 50 25 00 25 50 26 00 26 50 27 00 27 50 28 00 28 50 29 00 29 50 30 00
-1 0 0
Long Straddle
Buy same strike price call and put option. It is beneficial when market looks very volatile. Trader has to pay time value.
Purchase 2600 March Call option at Rs.75 and 2600 March Put option at Rs.75
Events Price Of Nifty Value of I Value of II Profit / Option Option (Loss) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000 -75 -75 -75 -75 -75 -75 -75 -75 -75 -25 25 75 125 175 225 275 325 325 275 225 175 125 75 25 -25 -75 -75 -75 -75 -75 -75 -75 -75 -75 250 200 150 100 50 0 -50
P a y o f f o f L o n g S t r a d d le
400 300 200 Profit / (Loss) 100 0
22 00 22 50 23 00 23 50 24 00 24 50 25 00 25 50 26 00 26 50 27 00 27 50 28 00 28 50 29 00 29 50 30 00
-1 0 0 -2 0 0
P r i c e o f N i fty
Short Straddle
Sell same strike price call and put option. It is beneficial when market looks range bound. Trader will receive time value.
Sell 2600 March Call option at Rs.75 and 2600 March Put option at Rs.75
Events Price Of Nifty Value of I Value of II Profit / Option Option (Loss) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000 75 75 75 75 75 75 75 75 75 25 -25 -75 -125 -175 -225 -275 -325 -325 -275 -225 -175 -125 -75 -25 25 75 75 75 75 75 75 75 75 75 -250 -200 -150 -100 -50
Pay off of Short Straddle 200 100 Profit / (Loss) 0 2200 -100 -200 -300 -400 Price of N ifty 2350 2500 2650 2800 2950
Long Strangle
Buy Different strike price call and put option. It is beneficial when market looks very volatile. Trader has to pay time value.
Purchase 2700 March Call option at Rs.50 and 2500 March Put option at Rs.50
Events Price Of Value of I Value of II Profit / Nifty Option Option (Loss)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000
-50 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50 0 50 100 150 200 250
250 200 150 100 50 0 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50 -50
P a y o f f o f L o n g S t r a n g le
300 250 200 150 100 50 0 -5 0 -1 0 0 -1 5 0
Profit / (Loss)
-100
22 00 22 50 23 00 23 50 24 00 24 50 25 00 25 50 26 00 26 50 27 00 27 50 28 00 28 50 29 00 29 50 30 00
P r i c e o f N i fty
Short Strangle
Sell different strike price call and put option. It is beneficial when market looks range bound. Trader will receive time value.
Sell 2700 March Call option at Rs.50 and 2500 March Put option at Rs.50
Events Price Of Nifty Value of I Value of II Profit / Option Option (Loss)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000
P a y o f f o f L o n g S t r a n g le
150 100 50 0 -5 0 -1 0 0 -1 5 0 -2 0 0 -2 5 0 -3 0 0
22 00 22 50 23 00 23 50 24 00 24 50 25 00 25 50 26 00 26 50 27 00 27 50 28 00 28 50 29 00 29 50 30 00
100
Profit / (Loss)
100
P r i c e o f N i fty
Long Butterfly
Sell same strike price call and put option & buy lower strike price put & higher strike price call (of equal distance). It is beneficial when market looks range bound. Trader will receive time value.
SELL 2600 2600 2800 2400 Events Price Of Nifty Value of Value of Value of Call Sold Put Sold Call Bought CE PE CE PE Value of Put Bought Profit / (Loss) 100 100
BUY
25 25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000
100 100 100 100 100 100 100 100 100 50 0 -50 -100 -150 -200 -250 -300
-300 -250 -200 -150 -100 -50 0 50 100 100 100 100 100 100 100 100 100
-25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 25 75 125 175
175 125 75 25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25 -25
P a y o ff o f L o n g B u tte r fly
200 100 0 Profit / (Loss) 2 2 02 02 52 03 02 03 52 04 02 04 52 05 02 05 52 06 02 06 52 07 02 07 52 08 02 08 52 09 02 09 53 00 0 0 -1 0 0 -2 0 0 -3 0 0 -4 0 0 P r ic e o f N ifty
Short Butterfly
Buy same strike price call and put option & sell lower strike price put & higher strike price call (of equal distance). It is beneficial when market looks volatile. Trader will pay time value.
SELL 2600 2600 2800 2400 Events Price Of Nifty Value of Call Bought Value of Put Bought CE PE CE PE Value of Value of Call Sold Put Sold Profit / (Loss) 25 25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000
-100 -100 -100 -100 -100 -100 -100 -100 -100 -50 0 50 100 150 200 250 300
300 250 200 150 100 50 0 -50 -100 -100 -100 -100 -100 -100 -100 -100 -100
50 50 50 50 50 0
P a y o f f o f S h o r t B u tt e r f ly
400 300 200 Profit / (Loss) 100 0 2 2 0202 5203 0203 5204 0204 52 05 0205 5206 0206 5207 02 07 5208 0208 5209 0209 5300 0 0 -1 0 0 -2 0 0 P ric e o f N ifty
Calendar Spread
Sell a call or put option & buy same strike price call or put of far month. It is beneficial when disparity in volatility in different months found. Trader will receive time value.
Sell 2600 March Call option at Rs.110 and Buy 2600 April Call option at Rs.130
Events Price Of Nifty Value of Value of Call Sold Call Bought Profit / (Loss) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 2200 2250 2300 2350 2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000 110 110 110 110 110 110 110 110 110 60 10 -40 -90 -140 -190 -240 -290 -125 -122 -117 -110 -101 -88 -72 -51 -27 1 33 67 106 146 190 233 280 -15 -12 -7 0 9 22
P a y o ff o f C a le n d e r S p r e a d
400 300 200 Profit / (Loss) 100 0 -2 0 0 -3 0 0 -4 0 0 P ri c e o f N i fty
22 00 22 50 23 00 23 50 24 00 24 50 25 00 25 50 26 00 26 50 27 00 27 50 28 00 28 50 29 00 29 50 30 00
38 59 83 61 43 27 16 6 0 -7 -10
-1 0 0
Option Greeks
Option Greeks represents Dimensions of risk involved in taking a position in an option. Option Greeks are : Delta Gamma Vega Theta Rho
Delta
The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. Means delta shows the net change in the price of option due to 1 Rs. Change in the price of underlying.
For Eg. If price of GNFC changes from Rs.100 to Rs.101 and the price of its 100 strike call option changes from Rs.5 to Rs.5.50. It shows that the delta of 100 strike call option is 0.50
Positive Delta
Negative Delta
Negative Delta
Normally Delta of Out of the money option lies between 0 to 0.49 Delta of At the money option lies at 0.50 Delta of In the money option lies between 0.51 to 1
Can delta go above 1 ?????????????????
Gamma
Gamma measures the change in delta for a given change in the underlying. Eg. If a call option has a delta of 0.5 and a gamma of 0.05, this indicates that the new delta will be 0.55 if the underlying price moves up by one full point and 0.45 if underlying price moves down by one full point.
Need of Gamma
Gamma anticipates the speed of delta which is very helpful at the time of running the delta neutral strategies. Because there we need to know the effect of delta due to change in spot price from one level to another.
Theta
Theta measures the effect of time decay on an option. As time passes, option will lose time value and the theta indicates the extent of this decay. Both call and put options are wasting assets and therefore have a negative theta. Note that the decay of options is nonlinear in that the rate of decay will accelerate as the option approaches expiry.
Eg. of theta
For Eg. If price of GNFC remains Rs.100 on Day 1 & Day 2 but the price of its 100 strike call option changes from Rs.5 to Rs.4.85. It shows that the theta of 100 strike call option is 0.15 for one day. (Annualised 54.75)
Vega
Vega measures the effect that a change in implied volatility has on an options price. Both calls and puts tend to increase in value as the volatility increases, as this raises the probability that the option will move in the money. Both calls and puts will thus possess a positive vega.
Volatility
The volatility of an option is a measure of the spread of the price movements of the underlying instrument. The more volatile the underlying instrument, the greater the time value of the option will be. This will mean greater uncertainty for the option seller who, will charge a high premium to compensate. Option prices increase as volatility rises and decrease as volatility falls.
Rho
Rho measures the impact on price of an option due to change in the rate of interest. It provides very less impact in short term maturity option while it is very important tool for long run maturity option.
Volatility Smile
Sell high vol option and buy low vol option. Delta Neutral
Bhavcopy
INSTRUMENT FUTIDX FUTIDX FUTIDX FUTIDX FUTIDX FUTIDX FUTIDX FUTIDX FUTIDX OPTSTK OPTSTK OPTSTK OPTSTK OPTSTK OPTSTK OPTSTK SYMBOL MINIFTY MINIFTY MINIFTY NFTYMCAP50 NFTYMCAP50 NFTYMCAP50 NIFTY NIFTY NIFTY TATASTEEL TATASTEEL TATASTEEL TATASTEEL TATASTEEL TATASTEEL TATASTEEL EXPIRY_DT STRIKE_PR OPTION_TYP OPEN 0XX 0XX 0XX 0XX 0XX 0XX 0XX 0XX 0XX 150CA 155CA 160CA 165CA 170CA 175CA 180CA HIGH 2634 2630 2645 1101.3 0 0 2634.8 2618 2619 13.05 10.3 8.2 5.75 5 2.5 2.85 LOW 2639 2631 2645 1101.3 0 0 2639.45 2625 2625 14.95 10.9 9.15 6.45 5.4 2.5 2.85 2538.4 2527 2525 1101.2 0 0 2538.4 2527.3 2525.05 8.5 6.15 4.4 3.1 2.4 2.5 1.4 26-Mar-09 30-Apr-09 28-May-09 26-Mar-09 30-Apr-09 28-May-09 26-Mar-09 30-Apr-09 28-May-09 26-Mar-09 26-Mar-09 26-Mar-09 26-Mar-09 26-Mar-09 26-Mar-09 26-Mar-09
Bhavcopy II
CLOSE SETTLE_PR CONTRACTS VAL_INLAKH OPEN_INT CHG_IN_OI TIMESTAMP 2556.8 2545.15 2543.75 1101.2 1180.2 1110.85 2556.8 2545.5 2542.1 8.9 6.4 4.8 3.15 2.65 2.5 1.55 2556.8 2545.15 2543.75 1018.9 1026.75 1032.4 2556.8 2545.5 2542.1 8.9 6.4 4.8 3.15 2.65 2.5 1.55 96215 7030 707 2 0 0 842741 20815 1347 197 30 520 12 303 1 140 49657.24 3612.7 363.1 6.6 0 0 1086216 26701.08 1728.48 481.01 75.12 1324.15 31.05 804.35 2.71 389.28 941780 130100 14360 600 0 0 32326450 1418400 131000 152800 169608 1326304 67232 774696 12224 764000 246300 28000 4180 600 0 0 1302250 233400 31700 74872 10696 155856 1528 59592 -1528 77928 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09 05-Mar-09
Open Interest
Meaning Use Exchange Regulation Calculation
The 1993 Metallgesellschaft oil hedging debacle The 1994 bankruptcy of Orange county The 1995 collapse of Barings bank The 1998 LTCM collapse The recent collapse of Enron
Metallgesellschaft
The Event
MGRM decided in 1991 to enter the US heating oil and gasoline markets
To do this, it offered retailers five and ten year fixed price contracts. These gave MGRM a short position of 160 million barrels of oil. MGRM hedged this position through purchase of NYMEX crude oil futures. MGRM used a stacked hedge, rolling over 1 and 2 month contracts. This exposed MGRM to cashflow risk (margin calls, since futures position large relative to cashflow) & basis risk (change in backwardation - contango at roll).
The problems
End 1993 oil price fell and NYMEX future moved into contango. Falling crude price forced large margin payments. Move to contango made the roll expensive. MG reacted in December 1993 by taking direct control of MGRM , and liquidating the hedge position. Liquidation cost Mg $1.83bn ,around one half of the total value of the firm.
Lessons
Highly speculative to hedge long-date position with shortdated instruments. MGRM was substantially over-hedged initial short exposure become a long exposure. Size of MGRM position induced contango. MGRM viewed synthetic storage as cheaper than physical storage. The contango was the price they needed to pay the market to do this storage. MGRM was a gamble that oil prices would rise from 199192 levels. The hedge was part of a speculative strategy to become a major player in the US oil refining industry.
Orange County
The Event
Citron dominates the orange county treasury in the 1980s and 90s. He was one of the nations best known municipal treasurers, primarily because his investment strategies produced a very high average return of 9.3 %. Citrons strategies consisted primarily of large, leveraged bets that short term interest rates would not increase. Citron borrowed about $13 billion from various securities firm through arrangements known as reverse repurchase agreements, using Orange countys $7.4 billion investment pool as collateral. This gave him about $20 billion to invest. Citron used structured notes to buy large amounts of inverse floaters, bonds whose value increases rapidly when interest rates decline and vice versa.
The problems
The federal reserve increased short-term rates on February 4,1994,and five times thereafter in the same year. Orange countys investment pool began hemorrhaging. Citron was able to hide these losses during 1994, because of the way in which his derivative investments were structured and as they technically fit within Orange countys investments guidelines. On December 1, 1994 Orange countys officials held a press conference announcing losses of $1.7 billion. Orange county was unable to repay the money it had borrowed and filed the largest municipal bankruptcy petition in history on December 6, 1994.
lessons
Naked directional bets will never succeed indefinitely citrons strategy gained only till interest rates remained low and once the rates started rising ,they resulted in large losses. Limited disclosure As citrons investments were shortterm and issued by highly rates entities. It technically fit within the orange county investment guidelines. However, The fact that they were structured notes with leveraged directional bets was never highlighted.
Barings bank
The Event
Leeson accumulated a very large long position in Nikkei stock index futures ($7b exposure) and to Japanese government bonds (JGBs) , both in Osaka and Singapore. Leeson was able to hide these losses from senior management in London. Leeson hid trading losses in an error account, the famous 88888 account.
The problems
The Nikkei fell following the kobe 1995 earthquake. Margin calls exhausted Barings reserves. Barings was sold for 1 to ING.
Lessons
Leesons background was not in trading but in futures settlement and he used his settlement experience to hide his trading losses.
LTCM
The Event
LTCM was a hedge fund involved in convergence (arbitrage) trades. They betted on convergence of German and other European bonds long and short term corporate & emerging market bonds versus US treasuries Russian and Japanese government bonds long and short term US equity swaption straddles. LTCM had very high leverage, which was further increased by the the December 1997 decision to return capital to investors. The leverage finally reached mare than 20 in 1988 , resulting in the fact that LTCM would make (or Lose) large amounts of money on small movements in relative rates.
The problems
Leveraged convergence trade made good profits for LTCMs investors over its initial three years of operations(1994-96). September 1998 Russian default resulted in rush into quality and huge increase in volatility resulting in all the convergence trades going badly Wrong. In the rush to quality following the Russian default, there were few buyers of corporate bonds. In September 1998 , the relative spreads widened instead of narrowing as LTCM had thought would happen. LTCM lost &4.6bn and there was a significant fear on the part of the regulators that LTCM bankruptcy might trigger other bankruptcies , inducing the fed to organize a $3.6bn rescue for LTCM.
Lessons
Liquidity risk : size is not always a benefit. Leverage: LTCMs equity base was insufficient to support the degree of leverage required to generate the returns they were promising to their investors. Basis risk : Even if basis risks on the different LTCM trades were small and uncorrelated, multiplied by twenty they became quite large.