In the last article, we learned about the the misadventures in futures and options of the 1630s with the tulip bubble in Holland. Today, we examine further derivative craft work that led to the failure of some organisations in the 1990s.
1994: Inverse floaters in Orange County
On Dec 6, 1994, the southern California district of Orange County declared bankruptcy, after suffering US$1.6 billion in losses from a wrong bet on interest rates in one of its investment pools. District treasurer Robert Citron used highly leveraged funds to go deeper and deeper into yield curve play strategies using interest rate derivatives.
The specific interest rate derivative was an inverse floater, a variation of an interest rate swap. A normal interest rate swap pays coupons of [Libor + X%] in return for a fixed rate of interest. An inverse floater pays a floating rate of [X% - Libor] in return for a fixed rate. Observe that with an inverse floater, the floating payment rises when the underlying floating rate (Libor) falls. When this happens, the price of the swap increases, as the price is simply the total present value of the floating payments minus the present value of the fixed payments.
The treasurer was betting that interest rates would not rise. From 1989 to 1993, US interest rates were falling. He invested heavily in inverse floaters and made some handsome profits during that period.
Another yield curve play was to borrow short-term and lend long-term. Orange County borrowed funds on the repo market, a money market where borrowers get short-term financing by pledging high quality securities. Part of the borrowed funds were lent back into the repo market at the longer end (with higher interest rates). The collateral received from the money lent was pledged on the repo market again and the cash was used to buy more notes. This vicious circle went on until the county was loaded with US$13 billion in debt. For a county with just over US$7.5 billion of capital funds, the pool had over US$20 billion worth of investments.
If short-term interest rates had remained the same or declined, this strategy would have paid off. But the tactic soured with a shift in policy, when in February 1994, the Federal Reserve implemented a succession of interest rate hikes. As interest rates climbed, the coupons from the inverse floaters fell and revenue decreased. The derivatives also plunged in value. Orange County was unable to honour its loans in the repo market. This spooked local government investors, who pulled out immediately. Wall Street counterparties also started demanding billions of dollars of collateral. Orange County was caught in a liquidity trap it could not escape.
1995: Equity index futures and straddle options in Barings
Barings Bank, a 200-year-old British bank, went bankrupt in 1995 with losses close to US$1 billion. One trader in its Singapore branch, Nick Leeson, caused the debacle by trading in equity futures and options.
The trader’s mandate was to arbitrage (or switch) between Nikkei 225 futures in Singapore and Osaka. This involves buying futures contracts on one market and simultaneously selling them on another at a higher price whenever a price difference is spotted. Margins on arbitrage trading are minutely small, since arbitrage trading is very common as everyone tries to take advantage of the price difference on a publicly traded futures contract. However, in arbitrage, one is buying something in one market while selling the same good in another market at the same time. Almost all risks are hedged and the strategy is not very risky.
But instead of arbitraging, Leeson made directional bets (that is without hedging) in the Japanese futures markets, using equity index futures and options. Compared to arbitrage trading, where the returns were small (and safe), this strategy was very lucrative (and risky).
An equity index or stock index tracks changes in the value of a hypothetical portfolio of stocks. An equity index future is an agreement between a party and the futures exchange to buy and sell the index of the stock exchange at a certain time in the future, at an agreed price. For example, A can go long (buy) the Nikkei 225 at 10,995 that expires in June 2010. Come expiry, if the actual index stands at 11,100, A would have made a profit of 105 (11,100-10,995). The principle is not very different from the tulip forward in the previous article, just with the underlying being an equity index. Index futures contracts are always cash settled as there is nothing to “actually buy or sell” in the case of an index. You simply pretend that you are buying the “index” and cash settle it at the expiry date. Leeson was long the Nikkei 225 equity index futures.
He also sold options, specifically straddles. A straddle is a call and a put at the same strike price and the same expiry. For example, dealer X writes (sells) straddles on Nikkei 225 with a strike price of 10,995 that expires in September 2010. Dealer X is actually selling a call and a put simultaneously. As he is the seller, X receives premiums on both the call and the put. If the index goes up, X suffers a loss. If the index goes down, X also suffers a loss. This strategy makes money for the dealer when the market remains stable. Any losses from the call or put are expected to be small and less than the premiums received at the inception of the straddle. Chart 1 helps us to visualise this trade through a profit and loss diagram.
But danger looms as soon as the market turns volatile. The dealer loses money when the index moves up or down in large momentums. Worse, as the writer (seller) of the option, his loss is unlimited. This is what happened to Leeson in the Barings case. Luck ran out when the Kobe earthquake sent the Asian financial markets into a tailspin and the Nikkei plunging. Leeson’s bet on a rapid and stable recovery by the Nikkei failed to materialise.
As losses mounted, it is said that Leeson bought even more Nikkei futures (hoping that the Nikkei would make a quick corrective come back) and sold Japanese government bond futures betting that Japanese interest rates would rise. They turned on him again with massive margin calls that the bank could not sustain.
Sources also state that Leeson did not keep the trades delta-neutral in order to avoid first order risk at the very minimum. In other words, he did not hedge his bets (perhaps with long straddles or futures) against the most obvious risk, the underlying index move.
Conclusion
Orange County declared bankruptcy allegedly due to derivatives trading, but more precisely due to the use of leverage in a portfolio of short-term Treasury securities. As for Barings, an employee with a mandate to hedge or to look for arbitrage opportunities turned into a speculator.
Countless measures and regulations are put in place all over the globe to guard against future mishaps that may well be caused by derivatives. Important areas include risk management, credit risk, liquidity risk, internal controls, model testing... the list goes on.
But more importantly, we need to accept that mankind has created a very versatile financial instrument which is here to stay. And as with anything else, flexibility allows one to bend towards good or mischief.
Jasvin Josen is a specialist in developing methodologies for the valuation of various credit products. She has over 10 years of experience in investment banking and the financial industry in Europe and Asia. Comments: [email protected].
This article appeared in Capital page, The Edge Malaysia, Issue 802, Apr 19-25, 2010.