The Dangers of Derivatives
DerivativesIn finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:an item that can or must be bought or sold, a future act which must occur, a price at which the future transaction must take place, and a future date by which the act must take place.Read on Wikipedia → can reduce an existing risk or create a new one. Problems arise when a position becomes much larger or more dangerous than the organisation understands, or when the recorded trades do not reflect the real obligations.
The final section of Hull’s introductory chapter describes two different failures. A trader may take risks outside their authority. A firm may also follow its own rules while relying on a poor estimate of risk.
When recorded protection does not exist
Jérôme Kerviel worked on stock-index trading at Société Générale. His job involved finding price differences between related positions, such as futuresIn finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.Read on Wikipedia → traded on different exchanges or futures compared with the shares in an index.
An index measures the performance of a group of shares. Trading a genuine price difference requires positions that balance the relevant market risk. Instead, Kerviel built large positions that depended on the market moving in a particular direction. He recorded fictitious trades that made those positions appear protected.
The recorded protection did not exist. The real positions therefore carried far more risk than the records suggested. According to the chapter, they grew to tens of billions of euros. After discovering them in January 2008, the bank closed them over three days at a loss of €4.9 billion.
The failure concerned both the trading and the controls. Kerviel’s knowledge of internal procedures helped him conceal the positions. Calling the activity arbitrageArbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which the unit is traded. Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge.Read on Wikipedia → did not make the underlying exposure balanced or the recorded trades real.
The chapter includes two other historical cases. Nick Leeson was meant to trade price differences in Nikkei 225 futures between Singapore and Osaka, but took positions on market direction. His losses of about $1 billion brought down Barings. At Allied Irish Bank, about $700 million of unauthorised currency trading losses by John Rusnak were discovered in 2002.
These cases show why checking the reported profit alone is insufficient. An organisation needs independent confirmation of what was actually traded and what obligations remain.
When the risk estimate is wrong
A position can also be dangerous without an unauthorised trade. The organisation’s estimate may simply fail to capture what could happen.
Before the financial crisis that began in 2007, many firms underestimated the possibility of a sharp fall in US house prices. They also underestimated how mortgage defaults in different regions could rise together.
This connection between outcomes is called correlationIn statistics, correlation is a type of statistical relationship between two random variables or bivariate data. It usually refers to the extent to which a pair of quantities are linearly related. More generally, an arbitrary relationship between variables is called an association, meaning the degree to which the variability in one can be accounted for by the other.Read on Wikipedia →. If defaults were largely independent, losses in one region might be partly balanced by better results elsewhere. A wider decline affecting many regions reduces that protection. A collection of positions can then lose much more together than an analysis of each one separately suggests.
Staying within a limit based on an incomplete model does not remove this problem. The position may comply with the rules while carrying a risk those rules were not designed to measure.
What meaningful control needs to cover
Hull argues for a clear purpose for derivatives, explicit risk limits, and daily monitoring of traders’ activity. This applies to companies using derivatives as well as financial firms trading them.
Checking actual trades helps detect hidden positions. Examining severe but possible scenarios helps reveal weaknesses in the assumptions. Neither process guarantees that every problem will be caught, so the results still need judgement and independent challenge.
The earlier articles show practical questions to ask. Can a futures position require more cash than its initial marginIn finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:Borrowed cash from the counterparty to buy financial instruments, Borrowed financial instruments to sell them short, Entered into a derivative contract.Read on Wikipedia →? Does an optionIn finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.Read on Wikipedia → position involve buying a right or selling an obligation? Are the trades that supposedly offset each other real and economically matched?
The position’s purpose, size, cash requirements, and possible losses need to be understood together. A reassuring strategy name cannot provide that understanding.