Derivatives Are Not Dangerous - Essay Example

Derivatives “Guns don’t kill people. People kill people unofficial slogan of the National Rifle Association. Engaging in derivatives can be highly rewarding if effective risk measures are taken, but they may also pose serious problems to its traders if they effective risk management strategies are not taken into consideration. The collapse of two companies – Barings Bank and MG Refining and Marketing (MGRM), is attributed to the mishandling of derivative decisions. In both cases, the companies failed because the managers did not manage risks well. In the case of MGRM, the managers of the company engaged in hedging and did not reduce risk, but rather increased it. In the case of Barings Bank, the manager used options but did not use the right risk management approaches to determine the most risky derivative businesses to engage in. In order to understand the danger of risk managers and traders in derivatives market, it is important to understand the backgrounds of the two collapsed cases. Barings Bank collapsed due to millions of losses registered by Barings Futures Singapore (BFS) in 1994 and 1995. Within that period, BFS made losses of £927 million. This loss led to the collapse of the company. The losses were caused by unauthorized activities of Nick Leeson, the head of BFS. The only activities that Leeson was allowed to undertake outside Singapore was switching (arbitrage operation) between Singaporean and Osaka futures exchanges (Reserve Bank of Australia, 1995). These operations were considered by the bank’s executive management as non-risky. However, Leeson engaged in other derivative businesses including long positions (purchase option) in Nikkei futures, short position (sell option) in Japanese Government Bond (JGB), and short volatility position in Nikkei exchange. Over January and February of 1995, the sequence of profits and losses from various positions of the derivatives fluctuated. Losses in one market were upset by profits from other markets at some point. At the end of February, all the markets in which Leeson held positions made losses. MGRM established large energy derivatives positions by engaging in hedging through forward-supply contract of delivering gasoline heating oil, and diesel fuel over a ten-year-period at fixed prices (Edwards and Canter, 1995). The company was then exposed to the risk of rising energy prices. MGRM sought to insulate its forward delivery contracts using energy futures contracts of maturity periods of two to three months. However, energy prices declined sharply in 1993. This caused the company losses and margin losses of $900 million. The company’s management rescued the company from plunging into bankruptcy by replacing top management of MG, liquidating all its derivative positions, and receiving $1.9 billion rescue operation from 150 banks from Germany and overseas. From these two cases, it is clear that speculative deals and risky derivative positions taken by managers lead the company into crisis. In this case, the derivative itself is not the dangerous thing because in any derivative contract there is a winner and a loser. The person who did not manage his risks well ends up losing while the person who calculated his risks and protected himself well from the risks ends up gaining. In order to engage in arbitration requires a high level of skills in the use of futures markets, especially in a highly risky products with highly fluctuating prices like energy. This is where the management of MGRM failed in its arbitration move when it engaged in forward delivery to arbitrate between spot oil market and long-term contract market. There are three risks that affect forwards and futures are: rollover risks, credit risk, and funding risk. Managers of MGRT did not put these risks into consideration. For instance, the company did not consider whether it would sustain gains or losses in the process of rolling its derivative position forward. The result is that the company was exposed to rollover risk. Generally, MGRM hedging strategy represented a mismatch of maturity between the hedge and delivery contracts of the company. Therefore, the derivative debacle of the company occurred not because the derivative was dangerous but because the managers did not manage risks effectively, and they failed to match the maturity of different derivative elements. The company engaged in highly speculative trade in an area where prices of the commodities traded is highly volatile. In such a case the trader is to blame for his actions, not the tool he/she uses to carry out such actions. In the case of Barings Bank, Leeson engaged in derivative activities without authority. From the decisions that he made concerning the options, it is clear that Leeson did not understand his business fully in the first place. When it is about derivatives, managers always have to predict, measure, and manage risks. One of the ways of managing risks is to avoid them. That is the position of the management when they authorized Leeson to carry out only one activity concerning risk – arbitrage between Singaporean and Osaka futures exchanges. The company understood that this derivative trade was not risky, but Leeson decided to carry out unauthorized derivative trades which turned out to be highly speculative. In order to enjoy profits from an arbitrage through options, futures, or forwards a derivative trader needs to understand the probability of making profits given their position and the maturity dates of their derivatives (Pasha, 2013). For the three positions that Leeson held, he should have considered at least one that has small risks so that it may offset any losses made by other positions. Regarding the authority given to the manager, it is clear that Leeson was given responsibilities in both back and front offices. As a result, he was able to conduct unauthorized trading and conceal them through fake accounts. Such secrets accounts parked losses until the company collapsed. From this account, it is clear that the actions of the manager led to the collapse of the business. In the case of MGRM, the activities of the management were not concealed, so it was able to rescue the company through liquidation of the derivative positions of the company. However, Leeson’s activities were concealed, and the company could not liquidate its derivative position. Oversight of activities by internal control or external auditors is always necessary to determine the position of the company in terms derivatives, so that it becomes easier to monitor and manage potential risks (Pasha, 2013). Leeson was not monitored or given sufficient oversight. Unlike in the case of MGRM where management realized its losses before the company could go into bankruptcy, Barings did not question Leeson or suspect anything about his activities until it was too late. This shows why Barings Bank collapsed while MGRM was rescued. From the above analysis of the two cases, it is plausible to conclude that derivatives are not dangerous. On the contrary, people who carry out trading activities on derivatives are dangerous. This is clear from the fact that MGRM was rescued from bankruptcy because its losses were discovered early while Barings Bank was not rescued because its losses were not discovered. Derivatives are not dangerous if they are handled well, they are only dangerous if they are mishandled. In other words, derivatives are not dangerous by themselves, the traders and risk managers are. Managers need to avoid highly speculative risks and manage their risks well while allowing for good oversight of their activities. References risk Edwards, F.R. and Canter, M.S. 1995. “The Collapse of Metallgesellschaft: Unhedgeable Risks, Poor Hedging Strategy, or Just Bad Luck?” Journal of Applied Corporate Finance, Spring. Pasha, S.A.M. 2013. “Retail Investors’ Perception on Financial Derivatives in India.” European Scientific Journal, 9(22), pp. 366-383. Reserve Bank of Australia 1995. Implications of the Barings Collapse for Bank Supervisors. Reserve Bank of Australia Bulletin. Read More