Financial Management of Risks 425WHAT WENT WRONG: CASE STUDIES
OF DERIVATIVES DEBACLES
Derivatives were not responsible for the financial calamities of the 1990s.
Greed, speculation, and probably incompetence were. But just as derivatives
facilitate risk management, they facilitate greed and accelerate the conse-
quences of speculation and incompetence. For example, consider the following
case histories and then draw your own conclusions.
Barings Bank
On February 26, 1995, Baring PLC, Britain’s oldest merchant bank and one of
the most venerable financial institutions in the world collapsed. Did this fail-
ure follow years of poor management and bad investments. Hardly. All of the
bank’s $615 million of capital had been wiped out in less than four months, by
one employee, half way around the world from London. It seems that a Bar-
ings derivatives trader named Nicholas Leeson, stationed in Singapore, had
taken huge positions in futures and options on Japanese stocks. Leeson’s job
was supposed to be index arbitrage,meaning that he was supposed to take low
risk positions exploiting discrepancies between the prices of futures contracts
traded in both Singapore and Osaka. Leeson’s job was to buy whichever con-
tract was cheaper and sell the one that was more dear. The difference would
be profit for Barings. When he was long in Japanese stock futures in Osaka, he
was supposed to be short in Japanese stock futures in Singapore, and vice
versa. Such positions are inherently hedged. If the Singapore futures lost
money, the Japanese futures would make money, and so little money, if any,
could be lost.
Apparently, Leeson grew impatient taking hedged positions. He began to
take unhedged bets, selling both call options and put options on Japanese
stocks. Such a strategy, consisting of written call options and written put op-
tions is called a straddle.If the underlying stock price stays the same or does
not move much, the writer keeps all the option premium, and profits hand-
somely. If, on the other hand, the underlying stock price either rises or falls
substantially, the writer is vulnerable to large losses. Leeson bet and lost. Japa-
nese stocks plummeted, and the straddles became a huge liability. Like a pan-
icked gambler, Leeson tried to win back his losses by going long in Japanese
stock futures. This position was a stark naked speculative bet. Leeson lost
again. Japanese stocks continued to fall. Leeson lost more than $1 billion, and
Barings had lost all of its capital. The bank was put into receivership.
Procter & Gamble
Procter &Gamble, the well-known manufacturer of soap and household prod-
ucts, had a long history of negotiating low interest rates to finance operations.