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Our wheat farmer sold wheat futures to reduce business risk. But if you were to copy the
farmer and sell futures without an offsetting holding of wheat, you would increase risk, not
reduce it. You would be speculating.
Speculators in search of large profits (and prepared to tolerate large losses) are attracted by
the leverage that derivatives provide. By this we mean that it is not necessary to lay out much
money up front and the profits or losses may be many times the initial outlay. “Speculation”
has an ugly ring, but a successful derivatives market needs speculators who are prepared to
take on risk and provide more cautious people such as farmers or millers with the protec-
tion they need. For example, if an excess of farmers wishes to sell wheat futures, the price
of futures will be forced down until enough speculators are tempted to buy in the hope of a
profit. If there is a surplus of millers wishing to buy wheat futures, the reverse will happen.
The price of wheat futures will be forced up until speculators are drawn in to sell.
Speculation may be necessary to a thriving derivatives market, but it can get companies
into serious trouble. The nearby Finance in Practice box describes how the French bank
Société Générale took a $7.2 billion bath from unauthorized trading by one of its staff. The
bank has plenty of company. In 2011 the Swiss bank UBS reported that a rogue trader had
BEYOND THE PAGEmhhe.com/brealey12eMetallgesellschaftBEYOND THE PAGEmhhe.com/brealey12eLTCM● ● ● ● ●FINANCE IN PRACTICE
❱ In October 2010, Jérôme Kerviel became the world’s
poorest man when a French court sentenced him to five
years in prison and fined him €4.9 billion. Until his arrest
two years earlier, he had been a trader in the French bank
Société Générale. But then it was discovered that he had
engaged in unauthorized trading, resulting in record
losses for the bank of €4.9 billion ($7.2 billion).
Kerviel joined the back office of SocGen in 2000.
Five years later he realized his dream when he was
promoted to be a trader on the Delta One desk, which
mainly trades equities, futures, and exchange-traded
funds.* In most banks the Delta One desk focuses on
arbitrage opportunities, and Kerviel’s job was to exploit
small price differences between equity futures con-
tracts, rather than to bet on the markets’ direction.
Soon after taking up his new position, Kerviel took an
unauthorized bet on a downturn in the market. The trade
proved successful and resulted in a profit of €500,000.
Although it was not hedged and exceeded Kerviel’s credit
limit, the bank took no action. Spurred on by this success,
Kerviel continued to take unhedged bets on the outlook for
the market. To hide the fact that his trades were unhedged,
he created a series of fictitious offsetting trades.
For a while fortune smiled on Kerviel and by 2007
he had made a profit of €1.4 billion. But in January 2008
everything started to unravel. As stock prices collapsed,
Kerviel took larger and larger bets that the markets would
recover. Every time he lost, Kerviel doubled up on his
bets. By mid-January, he had about €50 billion—more
than the bank’s total market capitalization—riding on a
market turnaround.
During early January, SocGen received several que-
ries from the Eurex derivatives exchange about unusual
trading patterns and the bank began to investigate Ker-
viel’s activities. By January 21, it had learned the full
extent of his positions and frantically moved to close
them out. The resulting loss of €4.9 billion amounted to
more than 10% of the value of the bank’s equity.
Société Générale’s failure to spot the unauthorized
trading was the subject of much criticism. Some com-
mented that a trader who had worked in the back office
would be particularly well informed about ways to hide
his activities. Banks took comfort in the fact that such a
breakdown in controls could never happen again—that
is until 2011, when the Swiss Bank, UBS, revealed that a
trader who had been promoted from the back office to the
Delta One desk had lost $2 billion in unauthorized trading.The World’s Poorest Man
*Delta One desks are so called because they trade equity derivatives that
have a hedge ratio, or delta, of 1.0 with the underlying securities. Delta One
desks, therefore, do not trade options.BEYOND THE PAGEmhhe.com/brealey12eMajor derivatives
losses26-7 Is “Derivative” a Four-Letter Word?