Financial Management of Risks 429Union Bank of Switzerland
What happened at Union Bank of Switzerland (UBS) in 1997 would be funny
if it weren’t so sad. Imagine a bakery that sells cakes and cookies for less than
the cost of the ingredients. Business would no doubt be brisk, but eventually
the bakers would discover that they were not turning a profit. This is essen-
tially what happened to UBS. UBS manufactured and sold derivatives to cor-
porate customers. Unfortunately, there was an error in their pricing model,
and they were selling the derivatives for too low a price. By the time they
found the mistake, they had managed to lose over $200 million. Swiss banking
officials concluded that losses sustained by the Global Equity Derivatives
Business arm of UBS amounted to 625 million Swiss francs (about $428 mil-
lion), but these losses stemmed not only from the pricing model error, but also
from unlucky trading, an unexpected change in British tax laws, and market
volatility. Some speculate that these losses forced the merger of UBS with
Swiss Bank Corporation, a merger that was arranged exactly when the deriv-
atives losses were discovered.
Long-Term Capital Management
The most surprising of the derivatives debacles is also one of the most recent.
It is the saga of Long-Term Capital Management (LTCM). LTCM was a com-
pany founded by John Meriwether, and joined by Myron Scholes and Robert
Merton. Meriwether had a reputation for being one of the savviest traders on
Wall Street. Scholes and Merton are Nobel prize laureates, famous for invent-
ing the Black-Scholes option pr icing model.^2 Unlike the folks at Procter &
Gamble, these individuals cannot plead ignorance. They were without a doubt
among the smartest players in the financial marketplace. Paradoxically, it may
have been their intellectual superiority that did them in. Their overconfidence
engendered a false sense of security that seduced investors, lenders, and the
portfolio managers themselves into taking enormous positions. The story of
LTCM is a classic Greek tragedy set on modern Wall Street.
LTCM was organized as a “hedge fund.” A hedge fund is a limited part-
nership, that in exchange for limiting the number and type of investors who can
buy in, is not required to register with the Securities and Exchange Commis-
sion, and is not bound by the same regulations and reporting standards imposed
on traditional mutual funds. Investors must be rich. A hedge fund can accept
investments from no more than 500 investors who each have net worth of at
least $5 million, or no more than 99 investors if they each have net worth of
at least $1 million. A hedge fund is essentially a private investment club, unfet-
tered by the rules designed to protect the general public.
Ironically, hedge funds are generally unhedged. Most hedge funds spec-
ulate, aiming to capture profits by taking risks. LTCM was a little different,
and for them the moniker “hedge fund” appeared to fit. Capitalizing on their
brainpower, LTCM sought to exploit market inefficiencies. That is, with an