EFB344 Risk Management

and Derivative
Lecture 11, Derivative
Disasters

Unit Outline
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam
Week 9: Forward Rate Agreements (FRAs) and Swaps
Week 10: Reflective Practice and Options 1 (intro and binomial model)
Week 11: Options 2 (Black-Scholes-Merton model)
Week 12: Options 3 (put-call parity, trading strategies and delta hedging)
Week 13: Derivative Disasters
Week 14: Revision

Lecture Outline

10 Largest Trading Losses

Leverage
Orange County
Socit Gnrale
Metallgesellschaft
Subprime Crisis
Credit Default Swaps
Morgan Stanley
Lessons

Readings
Hull et al. (2014), Ch. 8: 8.1 (skim 8.2 and 8.3), Ch. 23: 23.1 and 23.5 and
Ch. 25 (skim)
3

10 Largest Trading Losses

USD Equiv.
at time of
loss

Company

9.00 bn

Morgan Stanley

7.22 bn
6.50 bn
4.60 bn

Socit
Gnrale
Amaranth
Advisors
Long Term
Capital
Management

Product

Year

Credit Default
2008
Swaps
European Index
2008
Futures
Gas Futures
Interest Rate
and Equity
Derivatives
Credit Default
Swaps

Person(s)
associated with
incident
Hubler, Howie
Kerviel, Jrme

2006

Hunter, Brian

1998

Meriwether, John

2012

Iksil, Bruno

5.80 bn

JPMorgan Chase

2.62 bn

Sumitomo
Corporation

Copper Futures

1996

Hamanaka, Yasuo

2.52 bn

Aracruz

FX Options

2008

Zagury, Isac and

Sotero, Rafael

Leveraged Bond

1.70
bn of Orange
County
Citron,
Robert
Rank is in
order
losses in
2007 equivalent
dollars1994
(refer to
source)
Investments
Source: http://en.wikipedia.org/wiki/List_of_trading_losses
Metallgesellscha
Schimmelbusch,
1.59 bn

ft

Oil Futures

1993

Heinz

10 Largest Trading Losses

What can we note about the trading losses?
Theyre large
Most involve derivatives
Exception is Orange County (?)
It would appear that options were involved in only 2 of these disasters
Disasters associated with Credit Default Swaps enter in 2008 and 2012

All individuals listed appear to be men

All occur on or after 1993
When the full 45 reported on the Wikipedia site are examined,
all but 4 occur on or after 1993 and it would appear that the
individuals involved were all men

One of the common features of all these losses is that

they involve Leverage. Why? The other is men!
5

Leverage
Definition:

The use of various financial instruments or borrowed

capital, such as margin, to increase the potential return of
an investment (Investopedia (
http://www.investopedia.com/terms/l/leverage.asp).

Example: Invest $7,500 in CBA for T = 2/12, which

currently trades for $75 and has a If and , then

If
If

Leverage
Borrow
$7,500 at to invest in CBA, such that my

portfolio is
I own $15,000 of CBA
I owe $7,500 to someone

What is my return?

If
If
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Leverage
Buy
CBA at-the-money calls () with two months to
expiry for $2.
I own 37 CBA calls worth 2 x 100 x 37 = $7,400.
I give the remaining $100 to charity

What is my return?
is no longer the appropriate risk measure, because I
now own options
If
If

ming normality and a CBA return volatility of 15% p.a., theres approxim
8
hance that CBAs price will increase of decrease by $5 over a two-month

Leverage
Question: Generally, what is the value of a futures
contract, a forward contract and a swap at inception?
Answer: $0!
Question: What is the notional principal on a one
month Australian Dollar FRA?
Answer: $1,000,000,000 thats a billion!
Question: Can I borrow to buy options (leverage to
leverage)?
Answer: Why not!
9

Orange County
Business
Snapshot 4.2, Hull et al. (2014) p. 91

Trader: Robert Citron

Bet: Short Term Rates to stay Below Long Term Rate
()
Security:
Long Inverse Floating Rate Note
(Wilmott, 2001, p. 414):

where, and are multiplicative factors with

Leverage:
In part, it was through . Also he repo-ed
(sold with a
repurchase agreement) of bonds he
almost tripled the
exposure of the portfolio from
the initial $8 bn
(Wikipedia http://
en.wikipedia.org/wiki/Robert_Citron).

10

Orange County
What
happened?

Interest rate rose sharply, coupons go to zero given:

Orange County lost $1.7 bn and declared bankruptcy.

Paul Wilmott (2001, p.415) included the following
information when writing about Mr Citrons disaster:
During the sentencing phase psychologists found that he
had the math skills of a seventh grader and that he was in
the lowest 5% of the population in terms of his ability to
think and reason.
11

Orange County
On Robert Citrons death in 2013, the following appeared in a
New York Times article (http
://www.nytimes.com/2013/01/18/business/robert-citron-culprit-in
-california-fraud-dies-at-87.html?_
r=0):
Mr. Citron was not a stereotypical financial wizard. He drove a
Chrysler, ate lunch at the Elks Lodge (ordering the soup and salad),
wore discount suits and almost never visited New York to see the
investment bankers with whom he invested billions. He hated
weekends because he could not go to the office. He invested all his
own money in savings accounts and tax-free funds.
After a grand jury investigation found that Mr. Citron had consulted
a psychic and an astrologer as his investments shriveled, he pleaded
guilty to six felony counts of financial fraud, all related to his frenzied
activities to borrow ever more money and inappropriately shift it
from account to account. (He was never accused of acting for
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personal financial gain.) He spent a year behind bars.

Socit Gnrale
Business Snapshot 1.2, Hull et al. (2014) p. 18

Trader: Jrme Kerviel

Bet: Movement in European Stocks Indices
Security:
Equity Index Futures
Leverage:
Bank officials claim that throughout 2007,
Kerviel had been
trading profitably in anticipation of
falling market prices;
however, they have accused
him of exceeding his authority
to engage in
unauthorized trades totaling as much as 49.9
billion, a figure far higher than the bank's total market
capitalization
(Wikipedia http://
en.wikipedia.org/wiki/J%C3%A9r%C3%B4me_Kerviel).

13

Socit Gnrale
What happened?
Kerviel was using his knowledge of the back office systems, reporting and
procedures to hide his positions; a rogue trader.
The bank discovered these positions and started unwinding them. They
lost 4.9 bn over three-days!
From Wikipedia (http://
en.wikipedia.org/wiki/J%C3%A9r%C3%B4me_Kerviel )
On 5 October 2010, he was found guilty and sentenced to five years of prison, with two
years suspended, full restitution of the $6.7billion which was lost, and a permanent ban
from working in financial services.
On 24 October 2012, a Paris appeals court upheld the October 2010 sentence to three
years in prison with another two suspended, and ordered to reimburse 4.9bn euros to
Socit Gnrale for its loss.
In March 2014, a French high court upheld Kerviel's prison sentence but ruled he would
not have to repay 4.9bn.

If he went to prison on 24 Oct 2012. He has one year and one day until
being freed barring good or bad behaviour. Then again refer to http://
www.dw.de/french-rogue-trader-jerome-kerviel-leaves-prison/a-17907667
14

Metallgesellschaft
Business Snapshot 2.2, Hull et al. (2014) p. 70
Trader: Heinz Schimmelbusch. However, neither Hull
et al. (2014)
nor Wilmott (2001) name names.
Bet: It was not a bet. It was a hedge.
Security:
Oil Futures
Leverage:
A U.S. subsidiary of Metallgesellchaft sold
a lot of longdated (5 to 10 year) fixed price
contracts (e.g. forwards) on
heating oil and gasoline.
To hedge their exposure to changes
in market
prices, they bought futures contracts.
Unfortunately, because only short dated futures existed,
the
hedge employed a rolling hedge strategy
where longer
dated exposures are hedged with short
dated exposures it
works in theory.
15

Metallgesellschaft
What happened?
Oil prices fell.
With a large number of bought futures (estimated at 20% of all NYMEX
Oil Futures (Risklearn.com http
://risklearn.com/metallgesellschaft-how-not-to-hedge /)), losses mounted
and margin calls were made; $900 million (Wilmott, 2001, p. 418)
Theoretically, the fall in prices meant that their long-term contracts were
gaining. However, these contracts were OTC contracts that were not
marked- to-market, so the cash gains were not being realised
Hence, Metallgesellschaft started having cash flow issues.
Whats the best thing to do in crisis? Panic! (not really, try to stay calm).
Wilmott (2001, p.419) writes that some think that the management did
panic in that:
Metallgesellschaft closed out all of it futures.
They then, in agreement with their customers, abandoned all their long-term contracts.
Losses totalled 1.59 bn.

But if they had left the forward contracts in place, they faced losses if
oil prices eventually rose, which they did. The article in the link above
provides some interesting lessons regarding this disaster.
16

Subprime Crisis
Subprime crisis (overview)
Prime mortgage good credit quality
Subprime mortgage credit quality not so good, e.g. NINJA
loan (no income, no job and no assets)
Greed
borrowers - wanted short term profits and ignored risks
Salespeople/brokers paid commissions on the dollar amount of loans
they sold
bankers - bonuses on selling or betting on subprime bonds
banks regulation arbitrage and profit, profit, profit
investors sought highest yielding AAA securities (bonuses again)
credit ratings agencies - the more we rate the more we make

Borrowers start defaulting, home prices crash, subprime bond

prices became worthless, credit default swaps (CDS) and
synthetic collateralised debt obligations (CDOs) had to pay
their notional principal amounts or something similar
17

Subprime Crisis
Securitisation / Asset-Backed Securities (ABS)
example

Borrowers

Mortgage
Brokers

Banks use securitisation to fund future

loans and regulatory arbitrage.
Bank is paid a management fee

Bank
Mortgage Pool
Asset 1
Asset 2
.
.
.
Asset n
$100m

Special Purpose
Vehicle
(SPV)

Senior Tranche
(AAA)
$80m
BBSW + 60bp
Mezzanine Tranche
(BBB)
$15m
BBSW + 250bp
Equity Tranche
$5m
BBSW + 2000bp

Paid
1st
Paid
2nd
Paid
Last
18

Subprime Crisis
Collateralised Debt Obligations (CDOs) example

Mezzanine Tranche
(BBB)
$15m
BBSW + 250bp

Senior Tranche
(AAA)
65%

Paid
1st

Mezzanine Tranche
(BBB)
25%

Paid
2nd

Equity Tranche
10%

Paid
Last

Of the original $100m, $80m + 0.65 x 15 = 89.75m is AAA rated

Note that if the loan portfolio experiences losses of more than 10.25%,
he Senior CDO Tranche, which is AAA rated, starts to make losses in this example
19

Subprime Crisis
Housing Bubble Bursts 2007
Subprime borrowers could no longer afford their loans
Teaser/Introductory rates ended with the new rate setting much higher.
A lot of borrowers borrowed 100% and maybe some more.
Loans were non-recourse, which meant that the borrowers simply handed the
house back to the bank (the bank was the manager and most borrowers would
not know that someone else actually owned the loan) and walked away.
It is reported that 14.4% of all (prime and sub-prime) US mortgages were either
delinquent or in foreclosure by September of 2009. Moreover, the majority of
losses were concentrated in ten states (Wikipedia http://
en.wikipedia.org/wiki/Subprime_mortgage_crisis ).
Losses on defaulting loans averaged 75%.
Subprime ABS mezzanine tranches (BBB) had lost 97% of their value by mid2009 while the subprime CDO senior tranches (AAA) were almost worthless at
this time.

Ultimately, many of these ABS and CDO securities were held by the
banks because they were undertaking regulatory arbitrage in
that the amount of capital held against these investments was
relatively small given their AAA rating. Hence, higher return on
equity.

20

Subprime Crisis
ABS Security Issuance

Source: Acharya and Richardson (2009)

21

Subprime Crisis

Source: Acharya and Richardson (2009)

22

Credit Default Swaps

Credit Default Swap (CDS)
Buyer buys insurance against a credit event by some reference
entity over a period of time.
If the credit event occurs during the life of the CDS, the buyer will
receive a payment from the seller in line with the contract.
Why is it a swap?
Regular payment, e.g. quarterly, based on
some rate, e.g. 90bps p.a. and the
notional amount

CDS
Buyer

CDS
Seller

In case of the credit event, a payment

(e.g. the notional in exchange for
bonds) is made.

What is the credit event?

Depends on the contract. It could be bankruptcy, missing a debt payment, credit
23
downgrade or debt restructuring.

Credit Default Swaps

Synthetic CDOs
A CDO created from short CDS positions.
The short positions earn regular payments and only payout on the
credit event

CDS Pool $100m

(e.g. CDS written on
ABS or CDOs)

Tranche 3
75%

Paid
1st

Tranche 2
20%

Paid
2nd

Tranche 1
5%

Paid
Last

24

Credit Default Swaps

AIG (American International Group)
A large American based insurance company
Started its life in China
According to Reuters on 18 Sept 2008 (note the date is 3 days after Lehman
Brothers default) , AIG had written some $440 bn in CDS on AAA bonds
($57.8 bn was on subprime, wikipedia http://
en.wikipedia.org/wiki/American_International_Group ) and was experiencing
some significant losses and started asking the US government for
assistance. Compounding all this, AIG was facing a credit downgrade that
would result in them needing to provide some significant additional
collateral (cash) against all their short financial positions (Reuters http://
www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR859727
20080918
)
Ultimately, in September 2008 the US government provided AIG with an
$85 bn bailout in exchange for approximately 80% of the company. In March
2009, AIG paid $165 m in executive bonuses (Wikipedia http://
en.wikipedia.org/wiki/American_International_Group ).
25

Morgan Stanley
From Michael Lewis book The Big Short

Trader: Howie Hubler

Bet: Default on Subprime mortgages but not too much default
Security:
Long CDS and short CDS on AAA CDOs
Leverage:
Hubler was long $2 bn CDS on subprime bonds,
however, as explained by Michael Lewis (2010, pp.205-206),
There was, however, a niggling problem: The running
premiums on
these insurance contracts ate into the short-term returns of Howies
group. The group was supposed to make two billion dollars a year,
said one member. And we had this
credit default swap position
that was costing us two hundred
million dollars. To offset the
running cost, Hubler decided to
sell some credit default swaps on
triple-A-rated subprime CDOs, and take in some premiums of his own.
The problem was that the premiums on the supposedly far less risky
triple- A-rated CDOs were only one-tenth of the premiums on the
triple-Bs, and so to take in the same amount of money as he
was
paying out, hed need to sell credit default swaps in roughly ten times
the amount he already owned
[approximately $16 bn].

26

Morgan Stanley
What happened?
Sub-prime crisis
Morgan Stanley lost $9 bn
Howie Hubler resigned in October of 2008 with many millions of
dollars, Lewis (2010)
From Lewis (2010) pp. 206-207,
Inside Morgan Stanley, there was apparently never much question
whether the companys elite risk takers should be allowed to buy $16
billion in subprime mortgages The $16 billion in subprime risk Hubler
had taken on showed up in Morgan Stanleys risk report inside a bucket
marked triple A - They show up again in a calculation known as value
at risk (VaR). The tool most commonly used by Wall Street management
to figure out what their traders had just done, VaR measured the degree
to which a given stock or bond had jumped around in the past, with
recent movements receiving a greater emphasis than movements in the
more distant past. Having never fluctuated much in value, triple-A-rated
subprime-backed CDOs registered on Morgan Stanleys internal reports
as virtually riskless.
27

Lessons

Define risk limits

Take risk limits seriously
Do not assume that you can outguess the market
Do not underestimate the benefits of diversification
Carry out scenario analyses and stress tests
And there are others, e.g.

separate front, middle and back office

do not blindly trust models
do not ignore liquidity risk
manage incentives
make sure you fully understand the trades you are doing
never ignore risk management
28

Book and Journal References

Acharya V. V., & Richardson, M. (2009) Causes of the

financial crisis. Critical Review, 21 (2-3), 195-210.
Lewis, M. (2010). The Big Short. Camberwell, VIC: Penguin
Books,
Wilmott, P. (2001). Paul Wilmott Introduces Quantitative
Finance. Chichester: WS: Wiley.

29