9.5 The use and abuse of derivatives

Certainly there is some evidence that Wall Street equity prices have been affected

by heavy activity in stock index contracts, especially around expiry dates, and there

is a possible theoretical argument to support the view that derivatives trading makes

the cash markets more volatile and nervy. The argument is that in the past, when

people thought prices in a market were becoming too high, they would express their

bearish feelings by leaving the market. This would exert downward pressure on

prices and help to stabilise them. Now, however, they stay in the market but protect

themselves against risk by using the derivatives markets. No sale is made in the cash

markets and bearish opinion loses its restraining inuence on prices. Thus, although

spreading risks through derivatives reduces risks for the individual, it increases risk

for the system as a whole (systemic risk). This provides big prot opportunities for

the uninsured speculators but increases risks of bankruptcies.

Individual company losses through derivatives have become almost routine in

recent years. The most spectacular was the collapse of the British merchant bank

Barings in 1995. This was a case where it became clear that the management of the

bank did not know what was being done in their name and almost certainly did not

understand the complexities of derivatives trading and the extent of the associated

risks. Details of the Barings collapse are provided in Box 9.5.

Box 9.5

The case of Barings

The British merchant bank Barings Brothers was bankrupted in 1995, after losses of

more than £860 million accrued on the Singapore and Osaka derivatives exchanges. The

bank was the victim of its own star trader, Nick Leeson, and the absence of management

controls to monitor his activities. Leeson was responsible for both trading and back-

ofce records of his deals at Simex (the Singapore International Monetary Exchange).

He had started by running a hedged position in futures on the Japanese Nikkei stock

exchange index. The aim was to make money by arbitrage – taking advantage of different

prices on the Singapore and Osaka exchanges. However, he soon stopped hedging the

purchases made in Singapore and between 1992 and 1995 built up positions in futures

and options contracts on the Nikkei 225 (that is, he began speculating). In the early years,

this was highly protable for Barings and the management asked few questions about

his activities.

Leeson was gambling that the market would not be volatile – he would make losses if

the index either rose or fell by large amounts but would prot from the index remaining

stable. During 1994, the index remained within a narrow range and everything was ne.

However, in early 1995, the combination of a large earthquake in Kobe in Japan and a

turn in investor sentiment against Japanese markets drove the index sharply down. His

contracts began to show losses. He faced daily calls for additional margin payments.

He assumed that the Nikkei would soon recover and nanced these cash calls by

writing put options on the contract. If the Nikkei index had risen again, these put options

would have been abandoned, leaving Leeson with the options premiums as prot. He

sold at least 20,000 contracts expiring in mid-March. Each point of the Nikkei 225 futures

contract carries a value of ¥1,000, and so with the Nikkei 225 trading at levels between

18,000 and 20,000 in the rst few weeks of the year, each future would have had a value

of some ¥18–20 million.

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

Unfortunately for Leeson and for Barings, the Nikkei index fell over the period from

19,600 to 17,600. The options contracts were exercised and Leeson faced losses of

around ¥40 billion on top of the losses from the initial futures contracts. His total losses

exceeded the capital of Barings Bank. The bank collapsed. Most of Barings’ employees

were saved by Internationale Nederlanden Group, which bought Barings and took on

its losses for £1. Leeson was later jailed for the falsication of records in an attempt to

conceal his activities.

Other well-known problems associated with derivatives trading have included:

l	losses in the 1980s by Hammersmith and Fulham local authority in London in the sterling interest rate swaps market (see Box 10.6);

l	losses in 1993 by Metallgesellschaft, the fourteenth largest industrial concern in Germany, on futures and OTC swap contracts;

l	losses of $102 million on swap transactions by the large American rm, Procter & Gamble, in 1994;

l	losses in 1994 by Tokyo Securities of ¥32 billion, one third of the rm’s net assets;

l	losses of $1.5bn on foreign exchange derivatives trading by Kashima Oil, a Japanese company;

l	losses of ¥65bn on foreign currency dealings by Mazda, the Japanese car manu- facturer, in 1993/94;

l	losses of £15 million on writing currency options by the British company, Allied Lyons;

l	losses of £$1.1bn made by Toshihide Iguchi between 1984 and 1995 at the Manhattan Branch of Daiwa Bank on bad trades in the bond market;

l	losses of £91 million made by traders in 1995 and 1996 at Natwest Capital Markets, the investment banking arm of the National Westminster Bank in London, on deutschmark and sterling options and swaptions (see section 10.3) and covered up by the mispricing of options on the bank’s books;

l	losses of $691 million made between 1997 and 2002 by John Rusnak, working for Allrst Bank in Baltimore, on forward purchases of yen, allegedly hedged by com- binations of options and covered up through the development of ctitious options.

Many of these cases have had international implications. However, the most

dangerous case from the point of view of world markets in general was the near collapse

in September 1998 of the US hedge fund, Long-Term Capital Management (LTCM).

Hedge funds were originally US equity funds that hedged against market declines by

holding short, as well as long, positions. However, they were using derivatives to take

large bets on the direction of markets. Using a very complex system, LTCM risked

40 times its capital, a total exposure of $200 million. Although LTCM’s board included

Myron Scholes and Robert Merton, who had won the Nobel Prize for Economics for

their work on the pricing of options, their system could not cope with the nancial

crisis that had developed in South East Asia and Russia. As Tracey Corrigan wrote in

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