I’m reading “All That Glitters: The Fall of Barings” which is about the destruction of a solid 200 year old British bank. That occurred because rouge trader Nick Leeson out of the Singapore office in 1994 sold options on the Nikkei index. For some reason Leeson did not buy call options to offset the risk: the Nikkei fell and Barings collapsed.
I think I broadly understand derivatives and arbitrage but not in any detail.
At the beginning of the book they are explained and on page 8 (which talks about a farmer selling a wheat future) it says of early futures trading:
**“The participants soon realised this effect (the passing of risk to a future buyer) could be achieved without transferring the wheat.” **
Say whut??
Are futures contracts not actually performed? If I buy a contract for pork bellies for next Christmas I’m darned sure I expect a truck to arrive at my house.
But I can suggest a couple fun and educational reads:
F.I.A.S.C.O.: Blood in the Water on Wall Street and Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
both by Frank Partnoy. You might find either or both at your public library.
(If you still have a public library in your town.)
A futures contract is an agreement between two parties to buy/sell some commodity at some point in the future. Unless you sell your agreement to buy the pork bellies, you’d better make sure you have room in your freezer.
I’m guessing that they meant without transferring the wheat until the contract expires. The contract (aka the risk) could be traded back and forth amongst many different market participants without having to actually move the wheat from Bob’s to Joe’s barn every time a trade was made. When the contract expires delivery is made.
Exactly right, Trom. Here’s a more detailed note on Futures contracts.
Imagine you know a company called Juicers, Ltd. They make and sell Frozen Concentrated Orange Juice (FCOJ), which is sold on the Philadelphia Commodities exchange. Juicers might prefer to have their money faster, or at least a part of it. This makes it a lot easier to manage their finances, since they can have cash coming in year-round.
They could sell it all if they wanted to, but are probably hedging their bets and just selling a part. In order to do this, they might auction it or simply offer it at a discounted rate.
This becomes a contract. The person who buys it has a future deliverable (in FCOJ) from Juicers. However, this contract has value itself - the future price of the FCOJ. The new owner can sell it to anyone else.
Now look at it from the other side. Say you have a grocery store and you want FCOJ. You also might want to limit risk. After all, the orange crop could be damaged, and it often helps to have things nailed down before you resupply, right? So you tell brokers that you want to buy FCOJ. They sell you some FCOJ futures. Now you own a contractual delivery of FCOJ when it comes due, and the contract specifies that date.
What gets tricky is that you can sell a Futures contract which you don’t own. Commodities markets allow this. You then have to purchase an offset once the contracts come due, unless you’ve already filled it another way.
Bank A wants to bet that oil prices will go up, so they buy an oil futures contract (i.e., they agree to receive X barrels of oil on a certain date).
Bank B wants to bet that oil prices will go down, so they sell an oil futures contract (i.e., they agree to provide X barrels of oil on a certain date).
Now suppose that it’s getting towards the end of the contract period and Banks A & B don’t really want to receive or deliver any barrels of oil. In order to avoid this, they agree with each other that they won’t actually transfer the oil; they’ll just pay each other the cash equivalent instead. Problem solved!
What Smiling Bandit and Hogarth describe happens in a systemic way in the futures markets. Let’s use your original example of your future contract to acquire pork bellies. You can also, at some later time, enter into a future contract to deliver pork bellies, on the same terms. These two contracts are netted, so that you will neither acquire nor deliver pork bellies; you will simply have the financial effect of having entered into the two contracts.
This netting ability means that people can transact on the futures markets, even if they have no interest in entering into the underlying transactions. It expands the range of market participants and gives the market greater liquidity. It also makes it easier for individual investors to lose their shirts.
IIRC, in the last majoroil price run-up (when i hit $140/bbl back in 2008?) the financial news mentioned there were 10 times more futures contracts trading than actual oi deliveries. Most of those contracts were cancelled out in the manner mntioned above, but all that trading turned into a bubble market.
The big danger, as Barings found out, is that if the underlying commodity price changes way beyond expectations, you could lose your shirt. You can buy a contract for a fraction of the settlement price, but when it comes close to settlement futures prices tend to approach real world values. Of course, the alternative to delivering 100 truckloads of pork bellies could be to pay the other guy the same amount required for him to buy pork bellies from whomever he wants at the going market rate. Not much different than buying a contract and matching the two.
Worse is trading options -I will pay you $100 today if you will let me buy a futures contract for X pork bellies delivered at $20/ton sometime before Mar 31st. It’s safer - if PB goes over $20 you make money. If PB < $20 just don’t exercise the option. The person selling the option may be on the hook for a lot of money.
The futures contracts are performed, but no actual product changes hands until the expiration date. If it’s January 1, there’s no delivery until then. The aim of a investor/speculator is to sell the contract before its expiration date, to someone (say, a bacon salt manufacturer) who actually wants the physical pork bellies on January 1.
Now if it’s mid-December, and an investor hasn’t found anyone to buy the futures contract for Jan 1, the investor is going to start drastically dropping his asking price, because he really doesn’t want to have to deal with a call on Jan 1 asking where to deliver the pork bellies. Sucks to be the guy taking a huge loss, but that’s why it’s called ‘speculation’.
And of course some of the ‘delivery’ that happens on the expiration date isn’t actually moving product from one place to another, but transferring ownership of stuff that’s in a warehouse. New owner now has to start paying the warehouse storage fees until they can use the physical product, but there’s little or no physical change. I’m sure at some point, some investors have decided they’ll just pay storage for a while and hope the price comes back up.
In addition there are some futures or other derivative contracts that are “cash-settled”. This is true of all or at least most of the stock index contracts. Suppose I buy (go long) a DJIA futures contract at 12,500. Assuming I don’t sell the contract later to cancel, then on the expiration date, the final DJIA is compared to 12,500. If it’s say 12,625, then the futures contract is 125 points in the money and I would receive $10 x 125 or $1250 (There is also a mini-contract in which each point is worth $5 rather than $10).
The actual the way the contract works is a bit more complicated. The $1250 dollars would be credited in increments (positive or negative) each day to my margin account depending on the DJIA futures price each day. Note that it is the DJIA futures price which is used to make these determinations and not the DJIA itself. In theory the DJIA futures price should be in relation to the actual average by
DJIA futures Price = DJIA * [(1+r)(1-y)][sup]t[/sup] where r is the interest rate, y is the dividend yield, and t is the time until the contract expires. These adjustments arise because you don’t receive the intervening dividends nor do you have to actually put up the money to purchase now so you save the interest expense(though you do have to post collateral).
Thankyou everyone for a comprehensive discussion and explanation. I am much wiser now.
FYI Baring Brothers collapsed because its subsidiary Baring Securities (specifically Neeson) issued unauthorised put options on the Nikkei. This was a naked bet on the Nikkei rising in late 1994. Instead it fell and as you say, Barings was on the hook for a billion dollars.
Normally a trader will cover their position by buying call options but for some reason (haven’t finished the book yet) Leeson didn’t.
As I understood it, the actual trade was a short straddle, which means selling a call and a put at the same strike (usually the current spot price of the underlying). It is a bet that the value of the underlying won’t change much for the duration of the option, but if it changes a lot in either direction you lose big.
This deserves discussion. I’ve never heard this before but can understand how it could happen: perfectly legal, no fraud or dishonesty,…but doesn’t this have a touch of magic about it? Smoke and mirrors? Logically how can you sell or buy something which doesn’t exist?
Its trading for the sake of trading. Under this scenario derivatives are ephemeral constructs which evaporate. No goods and services are created or rendered.
The more I think about it the more this looks like gambling. That is artificial too but real money changes hands in both cases.
The core question is - should we allow financial markets to trade in contracts which cannot be performed? It just seems fundamentally wrong.
Thanks Leahim, you are correct. I’d missed that. The short straddle was based on fundamentals of a 5% swing in the Nikkei and initially it was profitable to Barings (Leeson). The whole mess happened because the guy was basically running the Singapore operation by himself and drawing margin call funds from London which had know idea of what was developing.
Earthquakes eh. We have had enough of those in NZ over the past year but the Japanese have suffered extraordinarily.
Yeah, the critical trade was more the “straw that broke the camel’s back” after a substantial period of undocumented trading losses, than a single deal busting the bank. Leeson was basically losing money and taking bigger and bigger bets to recover those losses, and that was the trade where his juggling act started to devolve into ball dropping.
There are times when trading futures you don’t expect to take delivery of is justified on more that just a speculative basis. The futures contract for oil, for example, specifies a specific grade of oil, to be delivered to a specific place on a specific day. If you want a different grade of oil, or a different place, or a different day, you’re still exposed to the price of oil and you might hedge your risk by buying futures, selling them on the day you want your oil, and using the cash to buy the grade of oil you actually want in the place you actually want it.
For example, airlines are exposed to the cost of airplane fuel, but the market for crude oil is more liquid. The dynamics of the price of airline fuel are similar to the dynamics of the price of oil (i.e. if oil goes up or down, you expect airline fuel to go up or down in roughly the same proportion), so the airline buys oil futures to hedge its risk. If the price of airline fuel skyrockets, the airline can say, “it’s expensive to fuel our planes now, but we made a fuck-ton of money on these oil futures we bought, so we’re OK”. They never intended to take delivery of crude oil ever, but they did have a risk limiting purpose for buying the futures.
Of course there are also a fuck-ton of banks in the market making money off speculation with no use for oil or any related product, but just because someone is not intending to take delivery doesn’t necessarily make them a naked speculator.
I understand the value to capital markets of being able to buy and sell derivatives. It adds liquidity and risk protection through hedging.
Fine. No problem. In the wake of the GFC though, these markets need to be examined. As I understand it the creation of debt instruments comprising of packages of mortgages on people’s homes were wildly successful with investors. So the issuers of these debt packages bundled risky loans (sub-prime) to meet investing demand. The world was flooded with capital looking to buy secure investments which was fine until people stopped paying their mortgages.
Its all very well for you and I to risk our hard earned money buying a derivative but much trading is done by merchant banks and funds using clients money. When it all goes wrong, the technicians on the trading floor, the managers upstairs etc take their own salaries, bonuses, and personal trading - and leave. Sometimes they even stay on. But the average Joe who trusted these folk with his 401K or life savings…he’s on the welfare queue.
