Derivative DisastersNeha Wadhwa, Roll No. 13EPGDCFM 2013-15IIFT

Agenda

• Derivatives and Uses

• Derivative Disasters• Sumitomo Corporation

• China Aviation Oil (CAO)

• Amaranth Advisors

• Other Derivative Disasters• Metallgesellschaft AG

• SouthWest Airlines

What is a Derivative ?• A financial instrument whose price is derived from one or more underlying assets• Contract between two or more parties• Value is determined by fluctuations in the underlying asset• Common underlying assets - stocks, bonds, commodities, currencies, interest rates and market indexes• Example : Tomato Ketchup (Derivative)

Tomato (Underlying Asset)

Uses of Derivatives• Price Discovery• Risk Management and mitigation via hedging• Improve market efficiency for the underlying asset

Derivative Disasters : Sumitomo Corporation• Yasuno Hamanaka the head trader of Sumitomo Corporation manipulated the world copper prices through his operations on the LME Copper futures market over the period of 1991-95. • This artificial increase in copper price resulted in increased profits for Sumitomo Corporation from selling copper. • Whenever any hedge fund or speculator who was aware of manipulation tried to take short position, Hamanaka invested more money into his positions thus sustaining the high price. • In 1995, due to increased copper production facilities particularly in China copper prices started declining. • Sumitomo were unable to get rid of their long positions in the futures market. • Net Trading loss at US $ 2.6 bn, about 10% of their annual sales.

Learning's from the Sumitomo disaster:• Regulators (LME, CME etc) are now more aware and proactive• Good corporate governance and risk management needed• Proper assessment from the risk

Derivative Disasters : China Aviation Oil (CAO)• CAO was bearish on the future prices of the oil and started speculating on the oil price in the year 2003 • By March 2004 the short derivative position resulted in USD 5.8 million in losses. • Instead of closing the positions, company kept increasing the size of trades in the hope of offsetting the losses already incurred. • Later their CEO also bought futures contract betting the oil prices to continue to rise. • However at time of delivery of his futures contract, oil prices dropped and he incurred more losses. • Eventually, losses totaled US $ 550 million and CAO wasn’t left with enough money to meet the margin calls of the counter parties.

Learning's from the CAO disaster:• Poorly executed strategy and lot of rollovers• Good corporate governance and risk management needed• Proper assessment from the risk

Derivative Disasters : Amaranth Advisors• This hedge fund was into energy trading and was consistently giving around 30% return to its investors• In 2005, a trader took large speculative positions by using natural gas futures• Due to hurricanes like Rita and Katrina, natural gas prices went through the roof• This earned Amaranth US $ 1 billion profit• Hoping for the repeat performance next year, trader went long on the natural gas contracts leveraging their position 8:1• About 50% of the US $ 9 billion hedge fund at stake on natural gas• However, that year US did not experience any major storm and on the back of increased supplier the natural gas prices plummeted• Net trading loss was about US $ 6 billion and the largest hedge fund collapse

Learning's from the Amaranth disaster:• Sound risk management procedures needed to be in place• Appropriate hedging strategy is crucial

Other Derivative Disasters :• Metallgesellschaft AG

Company adopted a flawed hedging strategy – going long on near term future contracts to protect against the forward sales commitments.

Spot prices fell resulting in forced margin calls and contracts were closed at loss Subsequently, the spot price increased and the company suffered even greater losses

covering its customer commitments Losses were of the order of US $1.3 billion

•SouthWest Airlines One of the most successful and profitable airlines in the world, SouthWest Airlines

strongly hedges its purchase of fuel by entering into huge value long term contracts. SouthWest had hedged 70% of its fuel at an average of USD 51/barrel, which till then

had been a celebrated strategy. However, as crude prices went down the advantage SouthWest had eroded. As a result, in 2008, the company reported its first quarterly loss in 17 years.