Gambling on Derivatives

Sir Julian Hodge

Memo, dated November 1990, to senior executives of the
Cardiff-based Julian Hodge Bank, quoted in the Western Mail, Tuesday,
February 28 1995.

Warren Buffett

The world’s greatest stock market investor, known as “the Sage of
Omaha”, in his Chairman’s Letter in the Berkshire Hathaway 2002 Annual
Report

Financial Derivatives Timeline

12th Century

In European trade fairs sellers sign contracts promising future delivery of
the items they sold.

What are Derivatives?

Derivatives are financial instruments that have no intrinsic value, but derive
their value from something else. They hedge the risk of owning things that are
subject to unexpected price fluctuations, e.g. foreign currencies, bushels of
wheat, stocks and government bonds. There are two main types: futures, or
contracts for future delivery at a specified price, and options that give one
party the opportunity to buy from or sell to the other side at a prearranged
price.

Derivatives and Speculation

The job of a derivatives trader is like that of a bookie once
removed, taking bets on people making bets.

Keynes on Speculation

“Professional investment may be likened to those newspaper competitions in
which the competitors have to pick out the six prettiest faces from a hundred
photographs, the prize being awarded to the competitor whose choice most nearly
corresponds to the average preferences of the competitors as a whole; so that
each competitor has to pick, not the faces which he himself finds the
prettiest, but those which he thinks likeliest to catch the fancy of the other
competitors, all of whom are looking at the problem from the same point of
view.”

“It is not a case of choosing those which, to the best of one’s judgment,
are really the prettiest, nor even those which average opinion genuinely thinks
the prettiest. We have reached the third degree when we devote our
intelligences to anticipating what average opinion expects the average opinion
to be. And there are some, I believe, who practise the fourth, fifth and higher
degrees.”

Keynes, John Maynard The general theory of employment, interest and money.
London : Macmillan, St. Martin’s Press, 1936. page 156.

Derivatives and the Nobel Prize for Economics

Although futures markets have existed in some form since at least the 17th
century, modern futures markets developed in the 1850’s with the opening of the
Chicago Board of Trade. However, since the early 1970s financial futures
markets dealing with currencies, shares and bonds have become much more
important.

In 1971 the Bretton Woods system of fixed exchange rates broke down when the
US suspended the convertibility of the dollar to gold. In a world of (mainly)
floating exchange rates exporters and importers faced new risks. A couple of
years later the Black-Scholes Model for determining the value of options was
published. Its use caught on quickly and by the 1990s many financial
institutions involved with derivatives were employing mathematicians and
physicists to design ever more sophisticated financial instruments.

In 1997 the Royal Swedish Academy of Sciences awarded the Bank of Sweden
Prize in Economic Sciences in Memory of Alfred Nobel (the Nobel Prize for
economics) to Professor Robert C. Merton of Harvard University and Professor
Myron S. Scholes of Stanford University, Stanford for their method of determining
the value of derivatives.

Merton and Scholes, in collaboration with the late Fischer Black, developed
a pioneering formula for the valuation of stock options. Their methodology has
paved the way for economic valuations in many areas. It has also generated new
types of financial instruments and facilitated more efficient risk management
in society.

The $3.5 Billion Rescue of LTCM

Just a year after Merton and Scholes received the Nobel Prize for their work a
hedge fund in which they were among the principal shareholders, Long Term Capital
Management, had to be rescued at a cost of $3.5 billion dollars as it was
feared that its collapse could have had a disastrous effect on financial
institutions around the world.

The Paradox of Hedging Risks

Why should a hedge fund that included two Nobel prize-winners among its
principal shareholders make staggering losses by trading in financial
instruments designed to reduce risk? There was, presumably, nothing wrong with
the techniques themselves, just the way in which they were used. It is
sometimes argued that measures to improve the safety of car occupants, e.g.
seat belts, increase risk by encouraging drivers to go faster than they would
without them.

It is possible that the sophisticated models that apparently enable risk to
be accurately quantified encourage risk taking by financiers who would
otherwise err on the side of caution. However that does not explain other
scandals that have involved derivatives, e.g. the collapse of Barings Bank or
the illegal trades in Swedish stocks by a member of the Flaming
Ferraris.

Derivatives Traders and Gamblers

Keynes may have been exaggerating when he wrote about investors who practise
the fourth, fifth and higher degrees of speculation. However, futures and
options are highly geared, or leveraged, transactions and therefore
traders/investors are able to assume large positions – with similar sized risks
– with very little up-front outlay.

By their very nature they encourage those
higher degrees of speculation so that derivatives traders behave, as, like a bookie
once removed. The potential rewards are such that a technique designed to reduce risk is all too
often treated as a gambler’s tool.

Mispriced Derivatives Scandals

Derivatives are sometimes deliberately mispriced in order to conceal losses or
to make profits by fraud.

Mispriced options were used by NatWest Capital Markets to conceal losses and
the British Securities and Futures Authority concluded its disciplinary action
against the firm and two of its employees, Kyriacos Papouis and Neil Dodgson,
in May 2000.

In March 2001 a Japanese court fined Credit Suisse First Boston 40 million
yen because a subsidiary had used complex derivatives transactions to conceal
losses.

In Seeing Tomorrow: rewriting the rules of risk by Ron S. Dembo and
Andrew Freeman, a case in which “clever but criminal staff got inside an
options pricing model and used tiny changes to skim off a few million dollars
of profits for themselves” is described on page 23. The culprits were not
prosecuted because the bank feared that the revelation could wipe out hundreds
of millions of dollars of its overall value.

Another possible case came to light in January 2006 when Anshul Rustagi, a London-based derivatives trader at Deutsche Bank was suspended after allegedly overstating profits on his own trading book by £30 million. He was subsequently dismissed.

Toxic Derivatives and the Credit Crunch

Credit default swaps were widely blamed for exacerbated the global financial crisis by hastening the demise of Lehman Brothers, AIG and other companies in 2008. By that year the derivatives market was worth over $516 trillion or about 10 times the value of the entire world’s output. This enormous ticking time bomb threatens to wreck international efforts to solve the world’s biggest financial crisis since the 1930s.

Early 17th Century

1634-1637 Tulip Mania in Holland

Fortunes are lost in after a speculative boom in tulip futures burst.

Late 17th Century

Dojima Rice Futures

In Japan at Dojima, near Osaka a futures market in rice is developed to
protect sellers from bad weather or warfare.

19th Century

1868 Chicago Board of Trade

Trading in wheat, pork belly and copper futures starts.

20th Century

Late 1960s

Black and Scholes begin collaboration

Fischer Black and Myron Scholes tackle the problem of determining how much
an option is worth. Robert Merton joins them in 1970.

After previously being rejected by a number of journals the paper was
published in the Journal of Political Economy which was one of the
journals that had previously rejected it.

Nick Leeson loses $1.4 billion by gambling that the Nikkei 225 index of
leading Japanese company shares would not move materially from its normal
trading range. That assumption was shattered by the Kobe earthquake on the 17th
January 1995 after which Leeson attempted to conceal his
losses.

The hedge fund is rescued at a cost of $3.5 billion because of worries that
its collapse would have severe repercussions for the world financial
system.

Some traders at CSFB are sacked following allegations of illegal trades in
an attempt to manipulate the Swedish stock market index.

21st Century

2001 Enron goes Bankrupt

The 7th largest company in the US and the world’s largest energy trader made
extensive use of energy and credit derivatives but becomes the biggest firm to
go bankrupt in American history after systematically attempting to conceal huge
losses.

John Rusnak uses fictitious options contracts to cover loses on spot and
forward foreign exchange contracts.

The US Defense Department had thought that such a market would improve the
prediction and prevention of terrorist outrages.

Four foreign currency dealers at the National Australia Bank are said to
have run up the losses in three months of unauthorised trades.

Citigroup traders led by Spiros Skordos made €15 million by suddenly selling
€11 billion worth of European bonds and bond derivatives, and buying many of them back
at a lower price.

November 2004 China Aviation loses $550m in speculative trade

This loss is the largest amount a company in Singapore has lost by
betting on derivatives since the case of Nick Leeson and Barings.

One of the world’s largest
derivatives brokers is forced to freeze trades.

the US-based hedge fund suffered enormous
loses trading in natural gas futures.

A rogue trader is blamed for the world’s largest banking fraud up to that date.

Steve Perkins, a futures broker with PVM Oil, was blamed for unauthorised trades that could have cost the firm £400m if they had not been discovered and closed.