FINA441, Chapters 13-15
Unfortunately, we do not have time to delve deeply into these chapters on derivative markets. This topic was
covered so some extent in Managerial Finance class. But we do want to pick out some key concepts which will
help us understand how a financial institution, such as a bank, can manage its interest-rate, default, and other risks
using derivative securities. Once we understand how derivatives are used to manage (hedge) risk, we want to
finish off by reviewing notable stories about how derivatives are used speculatively.
A. From the summary below (Derivative Securities: An Introduction), answer the following questions:
1. What is a derivative security?
2. Explain the key differences among futures, forward, and options contracts.
3. (a) Explain the difference between speculators and hedgers. (b) How are speculators good for the market?
4. Despite the horror stories, derivative securities are most often used to reduce risk rather than increase risk.
How might each of the following use derivative securities to hedge their risks:
(a) a bank that faces interest-rate risk,
(b) a stock investor
5. The fourth type of derivative security is a swap. Although we don’t have time to cover swap markets (Ch.
15) in any detail, we should spent a little time on credit default swaps and their new regulations. Refer to
the end of Ch. 15 in your textbook (10th edition, p. 400-402; 11th edition, p. 426-430) text for the following
questions:
(a) How is CDS similar to bond or mortgage insurance?
(b) Why did the CDS market grow so rapidly?
(c) How could a CDS contract be used to speculate on mortgage-backed securities?
(d) How did Lehman Bros. failure affect the CDS market?
(e) How was AIG connected to CDSs? Why did AIG not fail?
(f) How did the Financial Reform Act of 2010 regulate swaps?
B. Barings Bank was Britain's oldest merchant bank. It had financed the Napoleonic wars, the Louisiana
Purchase, and the Erie Canal. Barings Bank was where the Queen banked. When the bank failed, what really
grabbed the world’s attention was the fact that the failure was caused by the actions of a single, young trader
named Nick Leeson, based at a small office in Singapore. Google Nick Leeson and use Wikipedia or other
internet sources to answer the following questions:
1. Why was Leeson considered a celebrity within Barings Bank (before the crash)?
2. Briefly describe how Leeson brought down the bank.
3. In the end, what happened to Leeson?
Note: if interested, you can learn more from Leeson’s own website at http://www.nickleeson.com
Nick Leeson
C. Read the short article at the end of this document entitled “Orange County” and answer the following
questions:
1. What was the cost of the bankruptcy in terms of dollars and community impact?
2. Explain the strategy used by the county treasurer that made him the “envy of many municipal treasurers.”
3. How did his strategy backfire?
D. Many other examples of rogue derivative traders could be given. Review the table below and answer the
following questions:
1. From the list of rogue traders below, how many traders in the list were not trading derivative securities?
2. Which trader caused the largest loss?
3. Why is it easy to lose/win big with a derivative security?
Table of largest rogue trader losses
http://en.wikipedia.org/wiki/Rogue_trader
E. Up until the recent Madoff scandal, the largest fraud in banking history
involved the actions of a young, French derivative trader named Jerome Kerviel.
Use the Wikipedia table above to briefly answer the following questions:
1. What was the cost of this bank fraud?
2. What derivatives did Jerome Kerviel use to create these massive losses?
3. Take a guess at the strategy of Mr. Kerveil’s defense?
F. Complete the following problems from the back of chapter 13: #1,3,5,6,7.
We will work these problems in class.
DERIVATIVE SECURITIES: AN INTRODUCTION
A derivative security is one whose value is derived or based on the price of some other asset. This essentially
boils down to a side-bet on the future price of the underlying asset. For example, the value of a stock option is
derived from the value of the underlying stock price. Although new exotic derivatives are constantly being
created, the four most common derivatives today are forwards, futures, swap, and option contracts. These
derivative securities derive their values based on the price of any of a remarkable variety of assets, including:
(A) commodities (such as soybeans, gold, pork bellies, and orange juice)
(B) financial assets (such as common stocks, interest rates, bonds, stock indexes, and exchange rates), and
(C) environmental factors (such as weather or pollution).
In this class, we will briefly cover each of the four types of derivatives, but will focus of most our attention on
stock options.
Most derivative markets are relatively new and were not formally organized to any significant degree until the
1970s. Since then, they have grown to huge proportions and make up some of the largest markets in the world in
terms of dollars transacted. It is estimated that the total value of all derivative contracts outstanding worldwide is
nearly ten times worldwide GDP. Derivatives can be used to hedge (or insure) against risk or they can be used to
speculate (or increase risk). Most of time, the general public only hears about how derivatives were used to
speculate, as they have been associated with some spectacular losses and bankruptcies.
Examples of using derivatives to speculators:
 Barings Bank, Britain's oldest and the bank of the Queen of England, was forced into
bankruptcy by the $1.3 billion derivative trading losses of a 28-year-old, low-level
employee named Nick Leeson working in one of its Far East branches. (Historical
tidbit: this bank helped finance the Napoleon wars and the Louisiana Purchase.) See
Nick’s website http://www.nickleeson.com/
 Orange County, one of the largest and most wealthy counties in the nation, declared
bankruptcy due to $2 billion of losses incurred by its treasurer, Bob Citron, who was
speculating in derivatives. Among the many negative consequences was the inability to keep
the LA Rams from moving to St. Louis because a planned $60 million expansion of the
Anaheim stadium was no longer possible.
 A school teacher in College Place lost several thousand dollars very quickly by investing in heating oil
futures based on some promotion he heard on the radio.
 Proctor & Gamble lost $157 million in an interest rate swap.
 The largest U.S. insurance company, AIG, nearly collapsed in the fall of 2008 because it backed Credit
Default Swaps, which, under normal circumstances, provide legitimate credit insurance on bonds. But
speculators got a hold of these agreements and created a market for them, trading side-bets on the possible
failure of a particular company’s bonds. When Lehman Bros. bonds went bad, AIG was caught holding
the bag, backing multiple derivative securities with a value many more times the actual
value of Lehman bonds. In fact, in the fall of 2008, the total value of CDS was estimated to
be $58 trillion, which alone is more than worldwide GDP.
 French bank Societe Generale uncovered a $6.9 billion fraud -- one of history's biggest –
perpetrated by a single futures trader, Jerome Kerviel. His defense is that his superiors knew what he was
doing and condoned it as long as he was making money.
 JP Morgan Chase recently got a black eye for losing at least $2 billion in what was supposed to be
hedging activity on bond investments in its London office (known as London Whale Loss).
Hundreds of similar horror stories could be told. The problem stems from the highly-leveraged nature of
derivatives, where small miscalculations can be magnified into huge losses. Also, because derivatives are very
complex, they are seldom properly understood or their risks adequately assessed. This makes it difficult to place
adequate internal controls over derivatives. And it makes derivatives hard to regulate by governments. But with
all of this said, it must be emphasized that derivatives are used more to hedge (or insure) against risks than to
speculate in wild gambles. Unfortunately, the beneficial aspects of derivatives never make the headlines. Also,
keep in mind that the speculators bring players, capital, price discovery, and liquidity to a market that otherwise
might not exist. While the horror stories point out the need for proper management and control, they certainly do
not justify the elimination of derivatives or of speculators, as some people have suggested.
As opposed to speculators, those trying to reduce the risk of unexpected price changes are called hedgers.
Examples of using derivatives to hedge (reduce) risks:
 Heartland Ag, a large potato producer, expects the price of potatoes to drop, so it signs an agreement to
sell its potatoes today at current market prices for delivery in two months. McDonalds wants to have
potatoes in two months (for French Fries) and it thinks that prices will increase, so it agrees to receive
potatoes in two months but at today’s prices. If the price of potatoes increases, Heartland loses and
McDonald’s wins -- and vice versa. The objective is not to gamble, but that each company is taking
steps to address its risks arising from volatile potato prices.
 Disney World in Florida uses the derivative market to hedge against the risk of bad weather (they lose
millions every day it rains). On any given day, Disney bets that it will rain and speculators bet that it
won’t rain. If it does rains, Disney makes money on the derivatives to offset the losses from ticket sales.
Disney, which budgets $15 million a year for these derivatives, found this type of hedging cheaper than
buying business interruption insurance.
 ExxonMobil uses derivatives to hedge its exposure to foreign exchange rates and hydrocarbon prices.
 Many wheat farmers, including those in Eastern Washington, hedge their risks by using the futures
market to lock in grain prices ahead of time.
 Southwest Airlines uses derivatives to lock in prices of jet fuel as a hedge against rising fuel costs.
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Utility companies use weather futures (a side-bet on weather conditions) to insulate themselves from
unexpectedly warm winters and cool summers.
A Detroit company that sells de-icing compounds for airplanes/roads purchased $65,000 of snow futures
on the CME that would pay it $260,000 if Detroit’s airport received no snow in December. As it
happened, 9.3 inches of snow fell in December, so the company lost that gamble, but it made up for it in
increased sales. The company said it would enter a similar contract the next year because it provides
guaranteed profitability in the event of light snowfall.
Banks use interest rate futures to hedge their interest-rate risk.
Stock investors buy puts or sell calls to hedge the risk of their stocks tanking.
FORWARD, FUTURES, AND OPTIONS CONTRACTS
A forward contract is a non-tradable contract to buy or sell an asset in the future at an agreed-upon price. The
terms call for one party to deliver the goods to the other on a certain date in the future, called the settlement date.
The other party pays the previously agreed-upon price and gets the goods. An example might be a cattle rancher
and a food-processor who both agree to lock in the price of beef months before slaughter time. One of the biggest
forward markets is in foreign currency and interest rates, where parties try to hedge their risks by locking into
rates in advance.
A futures contract is similar, except it is a tradable contract to buy or sell an asset in the future at an agreed-upon
price. The value of the contract depends on the price of the underlying asset, which could be a non-financial asset
(commodities such as grain, oil, precious metals, meat, fruit, etc.) or a financial asset associated with foreign
exchange rates, interest rates, or various market indices. There is even such a thing as a weather future (a side-bet
on weather conditions) in which utility companies can insulate themselves from unexpectedly warm winters and
cool summers.
For financial futures, standardized denomination and pricing information exists, as follows:
Par Value of a Contract
Prices Expressed as:
T-Bills
$1,000,000
% of par, in decimals
T-Notes/Bonds
$100,000
% of par, in 32nds
Muni & Corp. Bond Index
$100,000
Index*1000, in 32nds
S&P500 Stock Index
n/a
Index*250
An option contract is similar to a futures contract except that it gives its owner the right to buy or sell some asset
at a certain price before a certain time. The main difference is that an option buyer has the option, but not the
obligation, to complete the contract. Options can be derived on the underlying value of almost any asset under the
sun, including cars (insurance is a form of a put option), common stock, interest rates, and of course foreign
currencies. Stock options are an important part of executive compensation, at least in America, since they are
considered performance-based compensation. Ch. 14 describes some of the basic characteristics of options.
The purchaser of a call option pays a fee for the right to buy an asset at a fixed price during a fixed period of time.
The fixed price is called the strike or exercise price. This is a bit like a coupon which allows you to buy orange
juice at the store for $1 a bottle, regardless of what actually happens to the price. You would, of course, hope the
price of orange juice goes up. Your coupon would be worth more as the price of orange juice climbs, so you
could sell your coupon at a gain.
A put option is the same idea except that the purchaser pays a fee for the right to sell as asset at a fixed price
during a fixed period of time. The purchaser hopes the price of the asset declines, because he is guaranteed the
right to sell the asset at the strike price, no matter how far the asset price drops.
Differences: The forward, futures and options markets are similar, but there are some clear distinctions. Forward
contracts, which are non-tradable, are generally tailor-made between two specific parties who carry the contract
through to completion and the underlying assets are actually delivered. Forward contracts are generally not later
traded with other parties but are kept between the original parties who signed the agreement. On the other hand,
futures contracts are standardized contracts (not customized). They are traded every day on an exchange with
daily market values established, and physical delivery of the underlying asset is virtually never taken. At the
settlement of the contract, the parties simply settle up with cash for the difference between the contracted price
and actual price. Most option contracts are traded over-the-counter but some are standardized and traded on an
exchange. In the case of futures and options, the parties entering into a contract never really intend to trade the
underlying asset in the first place. The futures and options contracts are simply side-bets on the future price of the
asset. An example would be when Hillary Clinton was able to make over $100,000 profit on a $1,000 investment
in cattle futures. Hillary never intended to buy or sell actual cows - she only bet on their future worth. (She really
shouldn’t get much credit for her success, since it was subsequently determined that these futures transactions
were mostly made by someone else on her behalf, in some cases illegally. Her only fame to claim at the time was
being the wife of the philandering Governor of Arkansas.)
Size of contract
Marketability
Security deposit
Clearing
Market place
Regulation
Length
Settlement
Forwards
Tailored
None
None
Individually
Cptr Network
Self
Varies
Actual delivery
Futures
Standardized
Marketable
Some
Clearinghouse
Exchange
CVTC & NFA
Usually < 1 yr
Mostly offset
Exchange Options
Standardized
Marketable
Some
Clearinghouse
Exchange
CBOE, NYSE
Usually < 1 yr
Sale or exercise
OTC Options
Tailored
None
None
Individually
Cptr Network
Self
Varies
Exercise
AN HISTORICAL PERSPECTIVE
Both forward and future markets originated in the agricultural industry of the Mid-West. Farmers were concerned
about the price of grain they would get after harvest in the fall, and the millers were concerned about the price
they would pay. Sometimes the price of grain would differ substantially depending on whether or not there was a
barge in dock at the time. The risks incurred by both parties could be reduced if they could lock-in a price earlier
in the year. So they entered into a "future" or a "forward" contract so that farmers could concentrate on growing
crops and the millers on milling grain, without worrying about the price.
In the early years, these contracts were arranged directly between the farmer and miller themselves, and the grain
was actually delivered by the farmer to the miller after harvest. Soon, however, middlemen entered the picture,
and a trading market in futures was established. The Chicago Board of Trade, formed in 1842, was an early
market in these dealings, and futures dealers (the middlemen) helped to make a market in futures contracts. Thus,
the farmers could sell futures and the millers could buy them in an organized, more efficient market, where the
cost of trading was reduced.
Eventually another group, called speculators, entered the scene. Speculators like the leveraged nature of
derivatives, where a small change in the price of the underlying asset (e.g. wheat) could cause a large change in
the price of the derivative (e.g. wheat future). Although speculators might at first appear to add risk to the market,
they actually tend to stabilize the overall market because they add capital, liquidity, players, price discovery, and
they absorb much of the risk themselves.
SWAPS
Another kind of derivative security is the swap, which is just what it implies -- two parties agree to swap
something. Swaps were formally introduced in the early eighties and their use has grown rapidly. Most swaps
either involve interest rates or currencies. For example, a company that has a fixed-rate loan but wants a variablerate one, will find another company that wants exactly the opposite. Or perhaps a company that has bonds
denominated in German marks but would rather be paid in dollars finds another company that wants exactly the
opposite. Usually the value of the swap to each party is not quite equal so a cash payment is required on the side.
Originally swaps were arranged by banks who would match up counter-parties. Such matching still occurs, but
today most swaps are between companies and banks, with the banks taking additional steps to make sure their
own risks are hedged.
A new kind of swap was created in the 1990s called a Credit Default Swap (CDS). This is a complicated swap
that essentially provides the buyer with credit insurance against the decline in value of a bond. Hedgers purchase
CDSs to project against a loss in value of their own bond investments, while speculators purchase CDSs as a sidebet that someone else’s bonds would tank. This certainly became the case when CDSs were sold on subprime
mortgage-backed securities. The largest U.S. insurance company, AIG, collapsed in 2008 because it was the
biggest backer of CDS, from which it had made a killing up to that time. When Lehman Bros. bonds went bad in
the fall of 2008, AIG was caught holding the bag, backing multiple derivative securities with a value many more
times the actual value of Lehman bonds. In fact, in 2008 the total value of CDS was estimated to be more than
worldwide GDP. Swaps are covered in Chapter 15 of your textbook. Unfortunately, we will not have enough
time to cover this chapter in great detail.
SUMMARY OF HEDGING WITH DERIVATIVES
If you think the price of your asset is going to fall, create a short hedge by selling contracts in futures, forwards, or
call options. You could also buy put options.
If you think the price of your asset is going to rise, create a long hedge by purchasing contracts in futures,
forwards, or call options. You could also sell put options.
TRADING PLACES
As already mentioned, Chicago is the capitol city of option and future markets in the U.S.
Trading is done at places such as the Chicago Board of Options Exchange (CBOE) and the
Chicago Mercantile Exchange (CME). The trading floors of these
exchanges are huge and take up whole floors of skyscrapers. For example,
the CME covers 60,000 square feet on just one of its trading floors. (See
http://www.gigapan.org/gigapans/8358/ for interactive pictures). The floor is broken into
pits with descending staircases so that traders can stand at different levels and see each
other. A pit will either be trading commodities (i.e. agriculture products, such as soybeans or hog bellies) or
financial derivatives (such as S&P500, Yen, or 30-Year T-Bonds). The game “Pit” got its name from the pits on
the trading floor of these exchanges. The traders usually trade derivatives in “contracts” and they use hand
signals to indicate whether are buying and selling and the number of contracts. In the game of Pit, when you yell
“two, two, two, two,” you are indicating that you want to trade two contracts of wheat, or barley or corn or
whatever.
Interesting career path of WWU business graduate
Ashley Gulke Leavitt is a 2004 WWU business grad. She was originally a farm girl from the Mid-West who now
works as a lawyer and well-known ag commodity analyst, among other things. Ashley has appeared as a
commentator on CNBC, a premier business TV channel in the U.S. See
http://video.cnbc.com/gallery/?video=3000081524 for an example (go to 7:30 minutes into the video).
Palm outward = sell; palm inward = buy.
WWU Grad: Ashely Gulke Leavitt
ORANGE COUNTY
BACKGROUND
Bob Citron
On December 5, 1994, Orange County, California, was the fourth richest county in the United States. Well
known as the birthplace of President Richard Nixon – and host to Disneyland and aerospace giants such as
McDonnell Douglas – the county collected an average tax bill of $5,700 per household and had a bank account
that prospered accordingly.
On December 6, 1994, Orange County filed for bankruptcy protection after a Boston bank demanded immediate
repayment of a billion-dollar loan that the county had used to purchase bonds. Within days, county residents
learned that they were experiencing the largest municipal collapse in U.S. history, as a result of $2 billion in
losses on a $20 billion investment pool managed by Robert Citron, former county treasurer. Initially, most of the
fault for the financial disaster was attributed to Citron. But as the details of his high-risk investments became
known, the blame spread to Merrill Lynch and Company.
At best, the brokerage firm had failed to reign in a client investing public funds unwisely. At worst, it had risked
the economic well-being of the Orange County community for its own profit. One county official, taking the
latter view, charged that the firm had gambled about $5000 for “each man, woman and child in Orange County” –
and lost.
With more and more municipalities turning to high-risk investments to offset reductions in federal grants, the role
of private companies in managing public money has come under close scrutiny from both regulatory and business
concerns.
Robert Citron’s Investment Strategy
Before the bankruptcy, Citron was seen as something of a wizard in public investment. His bold strategies- and
his average annual returns of 9 percent – were the envy of many other municipal treasurers, who found their hands
tied by state and local laws curtailing risk taking in the investment of public funds. Under pressure to earn more
money for the county after Proposition 13, passed in 1978, limited California’s tax – gathering ability, Citron
lobbied the state legislature to expand the investment powers of county treasurers. As a result of his efforts, he
was able to borrow vast amounts through arrangements called reverse repurchase agreements. This freedom
allowed Citron to take out short-term loans – in many cases from Merrill Lynch – and invest them in long-term
bonds that paid interest higher than the interest owed on the loans.
Through reverse purchases, Citron added 12.5 billion of bonds to the $7.7 million of public funds he managed
through the Orange County Investment Pool, in which public institutions such as school districts deposit their tax
receipts. Citron’s strategy worked as long as interest rates were falling, as they were throughout the 1980s. The
falling interest rates increased the value of bonds he had acquired with borrowed funds. When, however, the
Federal Reserve Board raised interest rates in 1994, Orange County was caught in a dangerous position: it had to
pay higher interest rates on its loans than it was earning on its investments. To worsen matters, the county’s
portfolio contained $8.5 billion in derivatives, including a type called inverse floaters, whose value decreases as
interest rates increase. (Derivatives are financial instruments whose value depends on, or is derived from, some
underlying financial asset, such as stocks or bonds.)
When the institutions that loaned Orange County the funds to make its reverse purchases learned that Citron was
not changing his strategy despite still-rising interest rates, they balked. CS First Boston demanded repayment of
its $1.2 billion loan, forcing the county to declare bankruptcy. Citron resigned on the same day.
The Community Suffers
Half a year after its resignation, Citron pleaded guilty to six charges of felony, admitting that he had lied to bond
investors and misappropriated public funds. Citron would be a key witness in Orange County’s $2.4 billion
lawsuit against Merrill Lynch to recover its losses.
But the immediate victim of Citron’s and Merrill Lynch’s actions was the Orange County community. The only
public services unaffected by the bankruptcy were police and fire protection. Work on new toll roads stopped,
and the widening of a major freeway was indefinitely postponed. The county canceled or postponed projects
ranging from school and courthouse renovations to a $60 million expansion of Anaheim football stadium meant to
keep the Los Angeles Rams from leaving the county (which the team did only months later). The transport
authority, which had $1 billion in the investment fund, worked out a plan to keep the county’s bus and rail
services running for 100 days. The county’s 185 school districts-also with $1 billion in the pool- worried about
being able to pay the monthly bills for items such as paper and lighting. In all, the bankruptcy action cost
approximately 5,000 private- sector jobs-mostly in the construction industry, because of cutbacks in the public
works program-and the county laid off 400 workers and eliminated another 300 positions.
One “plan for recovery” included cutting all county employee salaries by 5 percent and halting for the county’s
contribution to its employee retirement fund. All Orange County business and residents would eventually feel the
sting of higher taxes to refill the public coffer and compensate for the county’s rising cost of borrowing. The
community’s mistrust of its elected officials and big business was at an all time high. One angry Orange County
resident proposed a bumper sticker that read, “It’s 10 p.m. Do you know where your tax dollars are?”