Managed Derivatives: Trend Following Lesson

Copyright 1995 The Chronicle Publishing Co. The San Francisco Chronicle March 20, 1995, Monday, Final Edition Section: Business; Pg. D1; Business Insider Length: 798 words Headline: “Answering the Question — Who Wins From Derivatives Losses?” Byline: Herb Greenburg:

Each time there’s a derivatives disaster, I get the same question: If Barings was the loser, who was the winner? If Orange County was the loser, who was the winner? If Procter & Gamble was the loser, who was the winner? To understand who is on the other side of the trade, first you have to understand a little about derivatives. I asked Christopher Culp, a financial risk management consultant in Chicago for some answers. Culp is the first person I’ve run across who could actually put derivatives in laymen’s terms — or about as close to laymen’s terms as you can get with derivatives.First, in case you’ve forgotten what a derivative is: It’s a security whose value is tied to the price of some underlying asset.

Derivatives are generally used for hedging — as a way to minimize risk — but as Barings, Orange County and Procter & Gamble prove, they also can be used to gamble. Derivatives essentially come in three flavors: exchange-traded futures and options, derivatives securities and over-the-counter derivatives such as swaps. Futures and options contracts, when used for gambling purposes, are bets about the future prices of anything from the price of pork bellies to the movements of the Japanese stock market. This is where Barings landed in trouble. Derivatives securities are really nothing more than a fancy type of bond with an exotic name like a structured note issued by a corporation or government agency. These are what did in Orange County.

And swaps are contracts to exchange one asset for another. It can be a way to hedge against rising or falling interest rates, but it also can be used as a bet on interest rates. This is what got Procter & Gamble into trouble. As is the case with every security, there’s always someone else on the other side of a derivatives trade. ‘It’s a zero-sum game,’ Culp says. ”For every loser there’s a winner, but you can’t always be specific about who the winner is.’ That’s because with futures contracts, the opposing side technically is the clearing house, which settles the trades. The clearing house, in turn, pays the opposing investors, which in the case of Barings was probably many institutional investors — perhaps even some mutual funds. Barings was placing huge bets that the Nikkei Index of 225 Japanese stocks would rise. Whenever the index fell, Barings would have to pay money to the clearing house. ”If Barings lost $ 1 billion over the period of a year, they would literally have had to turn $ 1 billion over to the clearinghouse,” Culp says. (The mystery in money circles is where Barings came up with the money, because it didn’t have $ 1 billion; one theory is that it was forced to borrow the money.)

Unlike futures, it’s easy to identify the winner with derivatives securities because they’re created by specific corporations and government agencies. For example, many of the structured notes bought by Orange County were issued by Fannie Mae, the public company that deals in the mortgage market. By purchasing the structured notes, Orange County was betting that short-term interest rates would stay below long-term interest rates. As long-term rates fell, Fannie Mae didn’t have to pay as much interest to Orange County. That caused Orange County to wind up with a revenue short-fall. Finally, there’s the issue of swaps. You can always identify the winner here because it’s the bank or brokerage firm that creates the swap contract. Using a swap as a bet against changes in interest rates is like betting against the house in Las Vegas. Procter & Gamble, in effect, was betting against Banker’s Trust.

That meant it was betting on the direction of interest rates against one of the country’s biggest banks. When Procter & Gamble lost, Banker’s Trust pocketed millions. Procter & Gamble is now suing, claiming it was misled. Good luck. When swaps are used as a gamble rather than a hedge, Culp says, the house almost always wins. Copyright 1994 The Financial Times Limited; Financial Times November 16, 1994, Wednesday Section: Pg. XI Length: 1133 words Headline:”Survey of Derivatives” Byline: By Richard Waters:

Metallgesellschaft’s disaster in the oil derivatives markets is destined to remain a favourite business-school case study for years to come. Was the hedging strategy undertaken by the group’s US subsidiary, MG Corp, fatally flawed from the start? Or was it a panic by the group’s supervisory board in Germany (along with its bankers) that led to eventual ‘hedging’ losses of more than Dollars 1bn? With a batch of prominent US academics pointing the finger at the supervisory board in recent months, this arcane subject has taken on an unusual twist – prompting Metallgesellshcaft and its lead banker, Deutsche Bank, to mount a public defence of their position.

The facts are these. MG Corp signed long-term contracts to supply oil products to customers in the US at fixed prices. Then it used futures and swaps to protect itself against a rise in the oil price, which otherwise might have destroyed the profit margins on the supply contracts. During 1993 – and especially in the final three months of the year – the oil price plummeted, hitting the value of the derivative instruments held as hedges. In theory, that would not have caused a problem over the long term: if the oil price remained low, the derivatives losses would be balanced by higher profits on the oil supply contracts over time. But in the short term, MG had to pay out over Dollars 900m in the form of additional margin on its futures positions, and extra collateral to counterparties on over-the-counter swaps.

The result: a liquidity crisis of massive proportions, leading to an emergency line of credit from banks and a forced unwinding of most of the company’s derivative positions (and, apparently, also of its underlying supply contracts). According to the academics, this is where MG went wrong. In a joint paper, Professor Merton Miller, a Nobel laureate, and Christopher Culp, a graduate student, argue that the company’s ‘problem was not with its derivatives group, but more likely was with its supervisory board and supporting banks who may not have understood the hedging strategy and forced the premature liquidation of (its) hedge positions.’A paper by Culp and Professor Steve Hanke, of John Hopkins University, puts it more strongly still: MG’s ‘real operational risk was not that its supervisory board noticed the ‘problem’ too late, but rather that it misdiagnosed the problem entirely.’ It is not just the company’s board that is criticised: mistakes by regulators in the US also precipitated the losses, they claim.

There are three questions at the heart of the case. First, did futures regulators and the Nymex, where MG bought oil futures, add to the problems and indirectly force MG to liquidate its holdings? As the company’s liquidity problems emerged in early December last year, Nymex doubled the company’s margin requirements, adding to its cash problems. Later, it also took away the company’s hedgers’ exemption, effectively halving the position limits it was allowed to maintain on the exchange and preventing it maintaining its hedge positions.According to an MG spokesman: ‘The liquidation was, for the most part, determined by the unwillingness of OTC counter parties to trade with MG and the order by the Nymex to trade for liquidation purposes only.’For its part, though, the Nymex’s main concern was to protect the integrity of its clearing process and prevent MG’s losses hitting other members. Could it really be blamed for failing to extend privileges to a company that had brought a liquidity crisis down on itself?

The second, and most significant, question is whether, by liquidating its positions, the Metallgesellschaft board turned what were only paper losses into real ones. The unwinding was precipitated by the German group’s bankers, who balked at extending further funding to support the group’s hedging strategy. ‘This funding problem was the result of MG’s creditors not understanding (its) fundamental financial position,’ according to Professor Franklin Edwards, of Columbia University’s business school. ‘They should have been willing to lend against the specific collateral of these (derivative) contracts.’Professor Edwards is joint author of a textbook on futures and options with Ms. Cindy Ma, herself a risk manager with MG Corp during the fateful period. What this argument fails to take account of, though, is the funding costs that MG would have faced while waiting out the 10 years of its long-term supply contracts (and, according to the company, many of those contracts were structured for the bulk of the deliveries to be made right at the end of the ten-year period). Given its liquidity problems, the company’s cost of funds would have been high indeed.

Also complicating the question was the fact that MG was losing money every time it rolled over its oil futures contracts. On each rollover date, as it sold expiring futures contracts and bought new ones to carry the hedge forward, MG had to pay more for the new contracts than it received for the old ones (forward prices were higher than current ones, the equivalent of a positive yield curve).According to MG, this ‘rollover cost’ amounted to Dollars 20m-30m in each of October and November, and would have been Dollars 50m in December. The third question: should MG really have rushed to unwind its derivatives positions at what turned out to the be the very bottom of the market? Oil prices have risen around Dollars 4 a barrel since last December. Assuming MG had an open position of 150,000 barrels (as stated in a lawsuit brought against the company by its former head of risk management, Arthur Benson), it would have reduced its losses by Dollars 600m if it had waited until now to sell.

According to MG, though, the position it was rolling over in the market each month was so big that it was distorting the normal equilibrium of supply and demand. The company says its massive position was equivalent to 85 days’ worth of the entire output of Kuwait. ‘It is incorrect to assume,’ says an MG spokesman, ‘that the market would have rebounded if the company continued its scheme.’There is one other aspect of this sorry tale that deserves note. Having unwound many of its original supply contracts along with the derivatives, MG Corp no longer had the same need in the future to buy huge amounts of oil and oil products to sell on to customers. It had earlier signed long-term contracts to buy oil products from a US refining company, Castle Energy, at an agreed margin over market prices (MG also bought a large minority stake in Castle). In September, MG reached an agreement to terminate those contracts – at a cost, in terms of the debt and other claims over Castle it has given up, of around Dollars 500m.

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