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The Prentice Hall Series in Finance, ii
Copyright, iv
Preface, xv
Part I, 1
Chapter 1. Primer on Derivatives, 1
Introduction, 1
What Are Derivatives?, 3
Who Buys and Sells Derivatives?, 4
Where Are Derivatives Bought and Sold?, 4
Two Major Types of Derivatives, 5
Terminology That Is Common to All Derivatives, 5
Forward Contracts, 5
Options, 9
Risk Notepad 1.1: OTC-Traded Versus Exchange-Traded Derivatives, 13
Conclusion, 16
Review Questions, 16
Bibliography, 18
Part II, 19
Chapter 2. Employee Stock Options: What Every MBA Should Know, 19
Introduction, 19
Employee Stock Options: A Major Pillar of Executive Compensation, 21
Why Do Companies Use Employee Stock Options?, 22
Aligning Incentives, 22
Hiring and Retention, 23
Adjusting Compensation to Employee Risk Tolerance Levels, 24
Employee Tax Optimization, 24
Cash Flow Optimization for Companies, 25
Option Valuation Differences and Human Resource Management, 26
Risk Notepad 2.1: What Effect Do Employee Stock Options Have on Profits? Should They Be Recorded as Expenses?, 27
Problems with Employee Stock Options, 43
Employee Motivation, 44
The Share Price of “Good” Companies, 45
Motivating Undesired Behavior, 45
Improving Performance, 46
Absolute Versus Relative Performance, 47
Some Innovative Solutions to Employee Stock Option Problems, 47
Premium-Priced Stock Options, 47
Index Options, 48
Restricted Shares, 51
Omnibus Plans, 51
Conclusion, 52
Review Questions, 52
Further Reading, 54
Bibliography, 54
Chapter 3. Roche Holding: The Company, Its Financial Strategy, and Bull Spread Warrants, 59
Introduction, 59
Roche Holding AG: Transition from a Lender to a Borrower, 61
Loss of the Valium Patent in the United States, 61
Rapid Increase in R&D Costs, Market Growth, and Industry Consolidation, 61
Roche’s Unique Capital Structure, 62
Roche Brings in a New Leader and Replaces Its Management Committee, 64
A New Financial Strategy, 64
Roche’s 1991 Bull Spread Issue, 67
Why Did Roche Choose Long-Term, Dollar-Denominated Debt?, 67
Details of the Bull Spread Issue, 68
Target Investor Group, 68
Risk Notepad 3.1: What Are the Differences Between Options and Warrants?, 69
Analysis of the Bull Spread’s Return to Investors, 70
Analyzing the Bull Spread Issue from Roche’s Side, 80
Risk Notepad 3.2: Calculation of the Weighted Average Return on Roche’s Bond Cum Warrants, 80
Roche’s Bull Spread Issue: The Result, 86
Conclusion, 87
Review Questions, 89
Further Reading, 91
Bibliography, 91
Part III, 92
Chapter 4. Metallgesellschaft AG: Illusion of Profits and Losses, Reality of Cash Flows, 92
Introduction, 92
Metallgesellschaft: Evolution of the Company and Its Product Lines, 93
Energy Derivatives at MGRM, 94
Energy Markets on a Roller-Coaster Ride, 94
Risk Notepad 4.1: What Is the Difference Between Contango and Backwardation?, 96
MGRM’s Innovative Energy Derivative Products, 98
Understanding How MGRM Hedged Its Forward Exposures, 100
Payoff Profile of Short Forward Positions, 100
The Ideal Hedge Was Not Available, 101
Stack-and-Roll Hedge, 102
How Effective Is a Stack-and-Roll Hedge?, 104
MGRM’s Large Positions Create Problems, 114
MGRM Butts Heads with NYMEX and the CFTC, 115
MGRM’s Profitability: It’s All in How You Account for It, 116
MGRM’s Credit Rating, 117
The Effects of an Itchy Trigger Finger, 117
Was MGRM Hedging or Speculating?, 118
Corporate Governance Issues, 118
Conclusion, 120
Epilogue: What Happened to the Key Players in the MGRM/MGAG Disaster?, 121
Review Questions, 123
Further Reading, 124
Bibliography, 124
Chapter 5. Swaps That Shook an Industry: Procter & Gamble versus Bankers Trust, 126
Introduction, 126
P&G’s Motivation for the Swaps, 128
Motives for the U.S. Dollar-Denominated Interest Rate Swap, 129
Motives for the German Mark-Denominated Interest Rate Swap, 129
Motives for Using the Over-the-Counter Market, 130
The U.S. Dollar-Denominated Swap, 131
Plain Vanilla Swap, 131
P&G’s Gamble: The Speculative Side-Bet, 132
Risk Notepad 5.1: Security Yield versus Price, 135
Losses on P&G’s U.S. Dollar Interest Rate Swap, 140
German Mark-Denominated Interest Rate Swap, 142
The Suit Against Banker’s Trust, 144
Risk Notepad 5.2: Value at Risk, 146
The P&G-BT Settlement, 147
How Did BT Fare After the Swaps?, 147
P&G-BT from an Investor’s Perspective, 148
The Landmark P&G-BT Court Opinion, 149
Major Legal Issues, 149
An Unusual Court Opinion, 150
Summary of the Court Opinion, 151
Disclosure Reform After P&G-BT, 151
Should Corporate Treasuries Be Profit Centers?, 152
Conclusions, 153
Epilogue: What Happened to the Players in P&G-BT?, 154
Review Questions, 155
Further Reading, 156
Bibliography, 156
Chapter 6. Orange County: The Largest Municipal Failure in U.S. History, 158
Introduction, 158
Robert Citron and the Orange County Board of Supervisors, 159
The Orange County Investment Pool, 162
The Major Risks Facing Assets in the OCIP Portfolio, 164
Credit Risk, 165
Market Risk, 165
Liquidity Risk, 166
OCIP’s Assets and Funding Sources, 166
Structured Notes, 167
Risk Notepad 6.1: Other Assets in the OCIP Portfolio, 168
Fixed-Income Securities, 170
OCIP’s Funding Sources, 170
Leveraging the OCIP Portfolio, 172
Effects of Leverage on OCIP’s Return, 175
OCIP’s Rising Returns: Effects of Falling Interest Rates, 175
OCIP’s Return Stabilizes: 1993, 177
OCIP’s Returns Plummet: 1994—Effects of Rising Interest Rates, 177
The Consequences, 179
Market Risk Causes Liquidity Risk, 179
Government Paralysis, 180
Citron Resigns, 181
Lack of Liquidity Leads to Bankruptcy, 181
Fire Sale of the OCIP Portfolio, 181
Monday-Morning Quarterbacking, 182
Was Orange County Truly a Derivative-Related Failure?, 182
Was Orange County Really Bankrupt?, 183
Was It a Mistake to Liquidate the OCIP Portfolio?, 184
Could the Debacle Have Been Predicted?, 186
Sentences, Blame, and Reform, 186
Robert Citron, 187
Other Players: Matthew Raabe and Merrill Lynch, 188
Stealth Supervision: Shared Blame, 189
Governance Reforms, 189
Lessons Learned from Orange County, 190
Safety, Liquidity, and High Yield Are an Impossible Combination, 190
If You Can’t Explain It, Then Don’t Do It, 190
Conclusion, 191
Review Questions, 192
Further Reading, 193
Bibliography, 193
Chapter 7. Barings Bank PLC: Leeson’s Lessons, 194
Introduction, 194
Barings Bank PLC, 195
Nick Leeson: From London to Jakarta to Singapore, 196
What Was Leeson Supposed to Be Doing at BFS?, 197
Five Eights Account, 199
Risk Notepad 7.1: Error Accounts, 200
Leeson’s Trading Strategy: Doubling, 202
Funding Margin Calls, 203
Risk Notepad 7.2: Doubling, 204
Increasing Commission Income by Offering Deals at Non-Market Prices, 205
Using the Financial Resources of Barings as His Cash Cow, 205
Booking Fictitious Trades and Falsifying Records, 207
Risk Notepad 7.3: Leeson’s Most Flagrant Falsification Scheme, 208
Net Profit/Loss Profile of Leeson’s Exposures, 209
Leeson’s Long Futures Positions, 209
Leeson’s Short Straddles, 210
Profit/Loss Profile: Combining One Short Straddle and One Long Futures Contract, 211
Profit/Loss Profile: Combining a Long Futures Position and “Numerous” Short Straddles, 214
Massive Purchases of Nikkei 225 Futures Contracts, 215
Beyond Irony: The Barings Failure in a Broader Time Frame, 216
A Bank for a Pound, 217
Aftermath of the Barings Failure, 218
How Could Barings Have Caught Leeson Sooner?, 219
Conclusions: Leeson’s Lessons, 222
Epilogue: What Happened to the Key Players in the Barings Financial Fiasco?, 224
Review Questions, 229
Bibliography, 230
Chapter 8. Long-Term Capital Mismanagement: “JM and the Arb Boys”, 231
Introduction, 231
Risk Notepad 8.1: What Is a Hedge Fund?, 232
LTCM: The Company, 234
The LTCM Business, 234
The Principals, 234
LTCM’s Strategy, 236
Identifying Small Market Imperfections, 237
Using a Minimum of Equity Capital, 237
Securing Long-Term Funding, 242
Charging Hefty Fees, 243
LTCM’s Impressive Performance: 1994–1997, 243
LTCM’s Contributions to Efficient Markets, 246
Why and How LTCM Failed, 246
Exogenous Macroeconomic Shocks: U.S. and Global Spreads Widen, 247
Risk Notepad 8.2: What Is Contagion?, 250
Endogenous Shocks: Spreads Go Helter Skelter and VAR Gets Twisted, 250
Feedback Shocks, 253
The Fed, Warren Buffett, and the Rescue of LTCM, 256
Risk Notepad 8.3: Another Look at Warren Buffett’s Offer for LTCM, 258
Conclusions and Lessons to Be Learned, 260
Be Careful What You Wish For, 261
Beware of Model Risk, 261
All for One and “1” for All, 261
Leverage Is a Fair-Weather Friend, 262
Financial Transparency Is the First Step in Meaningful Reform, 262
In the Long Run, Bet on Global Financial Markets Being Efficient, 263
You Can’t Float Without Liquidity, 263
Some Things Are Worth Doing for the Greater Good, 263
Epilogue: What Happened to the Principals, Creditors, Investors, and Consortium?, 264
The Principals and Employees, 264
Creditors and Investors, 265
The Consortium, 266
Review Questions, 266
Further Reading, 267
Bibliography, 267
Chapter 9. Amaranth Advisors LLC: Using Natural Gas Derivatives to Bet on the Weather, 270
Introduction, 270
Amaranth Advisors LLC, 271
Natural Gas Markets, 273
Amaranth’s Natural Gas Trading Strategy and Performance: 2005 to 2006, 275
2005: Using Long Call Options to Bet on the Weather, 276
2006: Using Futures and Spreads to Bet on the Weather, 277
Risk Notepad 9.1: Measuring Natural Gas and Putting Amaranath’s Positions into Perspective, 280
Risk Notepad 9.2: Understanding How Profits Are Earned on Spread Trades, 281
What Caused Amaranth’s Catastrophic Losses?, 287
Inadequate Risk Management Practices, 287
Lack of Liquidity, 290
Extraordinarily Large Movements in Market Prices, 291
Explosion or Implosion? Who Got Hurt?, 292
Aftermath, 293
Did the Futures Markets Function Effectively?, 294
Did Amaranth Dominate Futures Markets, Engage in Excessive Speculation, and/or Conduct Regulatory Arbitrage?, 294
Did Amaranth Manipulate Prices?, 300
Risk Notepad 9.3: A Tale of Two Hedge Funds, 302
Conclusion, 308
Epilogue: What Happened to the Amaranth’s Traders and Managers?, 309
Brian Hunter: Chief Trader at Amaranth, 309
Nick Maounis: CEO and Founder of Amaranth, 310
Harry Arora: Trader and Former Head (and Later Co-head) of Amaranth’s Commodity Group; Brian Hunter’s Former Boss, 310
Matthew Donohoe: Trader at Amaranth Who Was Also Charged by FERC with Price Manipulation, 310
Assorted Other Things That Happened, 311
JPMorgan Chase & Co.: Amaranth’s Clearing Agent: Purchased Part of Amaranth’s Energy Book in September 2006, 311
Citadel: Hedge Fund That Purchased Part of Amaranth’s Energy Book in September 2006, 311
Paloma Partners Management Company: Hedge Fund That Nick Maounis Left Before Starting Amaranth and Which Provided Much of Amaranth’s Initial Funding, 311
Review Questions, 311
Further Reading, 312
Bibliography, 313
Glossary, 315
Index, 321

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