This chapter starts with an overview of the study and then presents the study’s problem statement, research questions and the researcher hypothesis. This section provides a detailed description of what the dissertation has set out to demonstrate and the expected findings.  It also has a summary of the chosen case studies, the research aims and objectives, a background of the study, the conceptual framework, the significance of the study and the definitions of terms used.

1.1  Overview

Derivatives, which can be defined as any financial instrument whose value depends on (or derives from) the value(s) of other, more basic, underlying variables (Hull, 2008), have been viewed as inherently bad financial instruments that have led to financial failures of companies and government institutions.

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According to Cochran (2007), the path to understanding the concept of derivatives, which most economists view as a positive innovation that emerged over the past 30 years, is a predominant factor in the global financial markets. Since many derivatives involve cross-border trading, the derivatives market has brought increased international financial fragility and the attendant need for greater supranational governance of derivatives (McClintock, 1996).

It is highly believed that risks, firm-specific and systemic ones, are increased by the derivatives market wherein the use of derivatives is perceived to have threatening effects on both the financial system and the real sector. It can be said that critics of derivatives fear firm-specific risks which include credit or default risk, legal risk, market and liquidity risk, operating or management risk (Becketti, 1995). Likewise, they fear systemic risks which entail greater competition between banks and non-bank financial institutions, greater interconnectedness of financial markets, increasing concentration of derivatives trading, reduced disclosure of financial information through off-balance sheet activities such as the case of Enron, and financial and telecommunication innovations that have intensified reactions to market disturbances.

Warren Buffet one of the world’s richest men  describes these in the Berkshire Hathaway Inc. 2002 Annual Report as being “financial weapons of mass destruction” and contracts devised by madmen. Moreover, cases such as those of Barings Investment Bank (Barings) in Great Britain, Metallgesellschaft AG (MG) in Germany, the Irish Bank Allied Irish Bank (AIB), China Aviation Oil (Singapore) in China, Sadia in Brazil, the Swiss Bank United Bank of Switzerland, Calyon in USA, Enron in USA, State of West Virginia in USA, State Reserves Bureau in China, Procter & Gamble in USA, NatWest in UK, MF Global in USA, Carnegie Investment Bank in Sweden, the Long Term Capital Management (LTCM) Hedge Fund in USA, Amaranth Advisors LLC (Amaranth) in Canada, Sumitomo Corporation in Japan, Orange County in USA, Caisse d’Epargne in France,  the Italian Bank Italease, Bank of Montreal in Canada, and the latest case involving the French Bank Societe Generale (SocGen), to mention some of the most popular, have elevated this popular notion that the use of derivatives is indeed the culprit that brings about massive failure and loss of enormous sums of money by companies and government entities.

 To provide some context about loss, below in table 1 are the top 10 trading losses ever (as noted by Babak). It can be noticed that all, except for one, are results of trading in derivatives.

Table 1

 According to Babak in an article published in March 2006,

“Trading derivatives is like juggling running chainsaws which also happen to be on fire. Unless you know what you’re doing, it will get messy. Each and every one of them started out as a small loss. The only reason why they are up on the board is that they were allowed to balloon into grotesque proportions. If we allow our convictions to overrule our discipline, we’re headed towards the same fate.

If anything, such gigantic losses should, dampen conspiracy theories of market manipulation. After all, if someone can’t bully a market with a few billion, then the market is indeed bigger than anyone and everyone.”

However, this dissertation firmly believes that it is the misuse of this financial instrument, and not derivatives per se, that cause firm failure or large losses. The cases of bankruptcy and severe financial loss reportedly due to derivatives need to be investigated to pinpoint the root cause of these incidents. For example, in Orange County and Barings Investment Bank, investigators found that the massive financial losses were because of fundamental weaknesses in internal control (Marshall, 1995). Thus, this study proposes that derivatives, if properly handled by people who manage these, are very useful instruments for companies and governments.

This study contributes to the growing body of research that supports the benefits derived from using derivatives, such as, for example, offsetting business risks like fluctuating interest and foreign exchange rates and commodity prices (Adam and Runkle, 2000). Furthermore, this study believes that the costs of not using derivatives vastly outweigh the costs of using them. A clear indication that derivatives are indispensable tools in corporate investment portfolios can be seen by the 37.1% growth in the use of interest rate swaps, currency swaps, and interest rate options contracts between 1995 and 1996 (Morse, 1997).

The researcher intends to shed light on the misconceptions and myths about derivatives and show that the misuse of derivative instruments causes a firm or a government entity to collapse and not the instrument per se.

1.2  Statement of the problem

This dissertation is guided by the framework that derivatives are not the reasons why companies fail or make enormous financial losses, but rather, it is the mismanagement of these tools. The complexity of derivatives can be a contributory factor to this failure. However, it is not the inherent quality of derivatives that causes major losses (Adams and Runkle, 2000) and complexity is not a necessary element of mismanagement. Often this is the result of a “can’t-lose mentality” which fails to consider the downside of the investment (Muehring, 1995). To illustrate the claim that the misuse of derivatives, not the derivatives per se, causes firm failure, the researcher has chosen to study the cases of Barings Bank, MG, AIB, Enron, the LTCM Hedge Fund, Amaranth, Italease Bank and SocGen.

1.3 Summary of cases

1.3.1    Barings Bank PlC

 The bankruptcy of Barings, in early 1995, illustrates the problems that can occur when derivatives are used for speculation and when the trading activity is not properly controlled. Although the Bank had more than two centuries of experience in the financial world, it still fell to the misuse of derivatives. It all began when Nicholas Leeson, one of its traders in Singapore, bought thousands of exchange-traded futures contracts based on the Nikkei Average and traded on the Tokyo Stock Exchange. Believing that the Nikkei would rise, and hoping that his gain would be maximised, he bought the contracts without hedging, exposing himself to a potentially damaging loss (Baker, 1995). When the Nikkei index fell and the contracts became due, the bank collapsed because it could not cover the losses.

1.3.2    Metallgesellschaft AG (MG)

 Metallgesellschaft AG is a German conglomerate and a traditional metal company with several subsidiaries in its Energy Group. In December of 1993, MG publicly announced that the Energy Group is responsible for losses of about $1.5 billion. MG Refining and Marketing Inc. (MGRM) committed to sell, at prices fixed in 1992, certain amounts of petroleum every month for up to 10 years. MGRM provided a method that enabled the customer to eliminate or shift some of their oil price risk. MGRM thought that their financial resources enabled them to manage risk transference in the most efficient manner.

However, the assumption of economies of scale is mistaken. MGRM attributed to such a great percentage of the total open interest on the New York Mercantile Exchange (NYMEX) that it made liquidation of their position problematic. Moreover, MGRM encountered problems involving the timing of cash flows required to maintain the hedge. There was a lack of necessary funds required to maintain their position. It seems that, despite the fact that this risk management strategy played a major role in acquiring business pursuant to their corporate objectives, management did not have an understanding of the strategy.

1.3.3    Allied Irish Bank

In 2002, AllFirst Financial, a subsidiary of Allied Irish Bank – Ireland’s second largest bank – lost US$750 million on foreign currency options trading. The Ludwig report attributes the losses to unsuccessful foreign exchange speculations. The company’s trader at the time, John Rusnak, systematically falsified bank records and documents to hide losses from speculative bets. The inadequate risk management procedures allowed Rusnak to cover the losses with both fictitious and genuine options positions without being noticed for over five years. Like Barings, the AIB disaster is a result of an operational exposure. The Ludwig report documents that the risk managers failed to perform overall reasonableness tests of the trader’s activities thereby not recognising that the level of daily turnover and the size of gross positions exceeded the given expected and budgeted profit/ loss and VaR limits.

1.3.4    Enron Corporation

Formed in 1985 by a merger between Houston Natural Gas and InterNorth of Omaha, Neb., Enron started off as a natural gas pipeline company. When gas and electricity deregulation hit in the late ’80s, the company moved into the business of buying and selling those commodities over the phone or by fax. Traders took orders from buyers, such as independent power companies, and then tracked down potential energy supplies. Within a year of deregulation, Enron’s gas services group had captured 29% of the electric power market. As the traders looked for new and better ways to aggregate and analyse market information, they realised that an online marketplace may be the answer.

     Enron became the seventh largest company in the US and the world’s biggest energy trader. It made extensive use of energy and credit derivatives but became the largest company to go bankrupt in American history after systematically attempting to conceal huge losses. In the wake of the Enron collapse, The Washington Post describes derivatives as “risky, complex and largely unregulated financial contracts.” In addition, The Baltimore Sun cited Michael Greenberger, formerly an official at the Commodity Futures Trading Commission, in stating that: “Derivatives, when used hypothetically amount to nothing more than gambling.” Even the author of the “Bowie Bonds” novel Linda Davies argues that “derivatives are financial instruments that have no intrinsic value” (Callahan &  Kaza, 2004)

     Derivatives did play a significant role in what was the second largest bankruptcy in American history (behind only WorldCom), but not in the way most people believe. Apparently, Enron a Houston Energy Company did not go bankrupt because it lost money in the derivatives trading. Enron reached the peak of success and profitability in its trading operations and is standing up billions of dollars in profits. According to Partnoy (2002), an economic historian, Enron went bankrupt because it tried to use the profits to disguise heavy losses in its technology and consulting businesses. Partnoy explained that as the accounting troubles surfaced, the company’s credibility and standing evaporated together with its sources of cash and credit. Enron is killed by a lack of cash flow and not a lack of profits (Prentice, 2002).

1.3.5 Long Term Capital Management (LTCM)

Initially enormously successful with annualised returns of over 40% in its first years, LTCM lost $4.6 billion in less than four months during 1998 and goes out of business in early 2000. It became the most prominent example of the risk potential in the hedge fund industry.  This  hedge fund was founded in 1994 by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers). Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economics, are on its board of directors.

1.3.6    Amaranth Advisors LLC

The star natural gas trader, a multi-strategy hedge fund founded by Nick Maounis in 2000 (one of the largest US hedge funds), lost about US$6 billion in a week, making it the largest financial loss made by a single trader. Burton and Leising (2006) stated that in June 2006, the company energy trades accounted for about half of the fund’s capital and generated about 75% of their profits.

Rick Brooks, a financial planner in Solana Beach, California, noted that the term “hedge fund” is very generic and compared it to saying that one is a doctor. Just as physicians run the gamut from brain surgeons to podiatrists, hedge funds vary generally in terms of investment strategy and risk level. However, hedge funds do share some extensive similarities. For beginners, like a mutual fund, a hedge fund puts investors’ money to work in the market. However, a significant difference is that these hedge funds are private and usually fell beyond the reach of government regulation. Although they did not have to register with the regulator in this case the Securities and Exchange Commission (SEC), the hedge fund managers have certain fiduciary responsibilities to their investors. Also, because hedge funds under this legislation are not allowed to advertise and promote, their operations, they are generally recognised as secretive or enigmatic. Information on the particular hedge funds is not available, to some extent, because managers do not want to unintentionally do something that might trigger regulator’s (SEC in this case) inquiry.

1.3.7    Italease Bank

A more recent case is that of the Italian Bank Italease.  Italease shares fell by 10.5% on the Milan bourse after the financial daily ‘Il Sole’ reported that the Bank of Italy intended to install its own interim management following a review of Italease’s disastrous bets on leveraged credit futures. The company, which was worth 2 billion Euro in April 2007, has lost three-quarters of its value.

The Bank sent out margin calls to 2,200 clients in an attempt to claw back 610 Million Euros paid to counterparties to stave off disaster after losses began to spiral out of control. These bets, as the bank’s spokesman Pierantonio Arrighi said, are related to Euribor interest rate contracts. It seemed that the derivatives team expected a slower pace of rate rise by the European Central Bank.

The bank started trading derivatives in 2003 but only experienced problems from January 2007. Many of the contracts are highly leveraged and included barriers referenced to Euribor – the instruments provided enhanced returns so long as Euribor remained within a pre-specified range. As European interest rates started to rise, the barriers are breached, causing sizeable mark-to-market losses for the bank.

According to Ambrose Evans-Pritchard, in an article in the Daily Telegraph, London, the debacle is a textbook example of overenthusiastic finance departments jumping into the $410,000 billion derivative markets to generate extra yield without understanding the full risks. The low-margin leasing bank became enthralled by the lure of apparently easy profits in future contracts. In two years starting in 2003, its income grew from nothing to a quarter of the bank’s total income in 2006.

Mr. Arrighi told the Daily Telegraph, “These very complex derivatives suddenly turned against us. They started moving in a non-linear way, so the losses were rising exponentially.”

1.3.8 Societe Generale

The latest and one of largest in history, by a single futures trader whose scheme of fictitious transactions appeared as stock markets began to stumble, is the case of French bank Societe Generale in January of 2008. The bank took a 4.9 billion euro ($7.18 billion) hit when closing the unauthorised positions of futures trader Jerome Kerviel. The losses that resulted are booked in the fourth quarter. Societe Generale says Kerviel has a position, or a bet, worth about 50bn euros ($73bn; £37bn) on the future direction of European shares. That is more than the bank’s value – about 35bn euros – and about the size of France’s entire annual budget deficit. To avoid that potentially catastrophic loss, the bank has to unwind Kerviel’s trades, (but as stated above it still costs 4.9bn euros). Societe Generale said Kerviel’s background in handling the administration of trades enabled him to deceive those monitoring traders’ activities. It says Kerviel invented deals that, on paper, balanced out his bets.

The above cases paint a picture of what can happen if derivatives are misused. Derivatives, as stated before, are inherently complex and this highlights the need for boards of directors and senior management to sufficiently understand these complexities and the uses of derivatives in their firms. Moreover, they must be able to monitor the risks associated with them and be cognizant that derivatives require a control structure that is in keeping with their complexities and the systems needed to adequately process the transactions.

1.4  Research Questions

The proposed research seeks to answer the following questions:

1. What are the benefits of using derivatives?

2. What are the consequences of misusing derivatives?

3. What are the inherent risks of using derivatives and how do they compare with the other financial instruments?

4. What were the lessons learnt from cases of derivative misuse?

5. What can be changed/improved to ensure the safe use of derivatives?

6. What is the future of derivatives?

1.6  Background of the Study

1.6.1    Evolving Financial Landscape

The global financial markets have evolved manifolds. For one, the US and its currency are dominating the world financial markets but nations similar to that of London and Tokyo are rapidly becoming centres of primary securities issues and secondary market trading. In a similar fashion, investment banks, securities firms, and futures and options exchanges have been posing challenges to commercial banks and stock exchanges which are once the dominant institutions. Furthermore, the once dominant onshore market, which was subject to strict regulation, has been overtaken by the offshore markets, which are subject to considerably less regulation.

Other changes in the global financial markets include the collapse of the Bretton Woods Agreement on pegged exchange rates in the early 1970s and the unexpected collapse of pegged rates in many countries such as Mexico, Thailand, Korea, Russia, and Brazil in mid-1990s. These events raised questions about the responsibility of investment managers and corporate treasurers in taking adequate steps to measure and manage their financial and operational risks. These changes in financial landscape have also added to the expanding menu of financial management choices.

1.6.2. Risk Management

With the rapid changes in financial markets, corporations need to adjust to these changes by emphasising the importance of risk management. Risk management has received increasing attention in recent years, both from academics and from practitioners. This heightened interest is the result of a number of coincident secular trends. For one, globalisation of trade and production has increased financial and direct investment in volatile emerging markets. The increased emphasis accorded to risk management is also due to the fact that, in both developed and emerging economies, capital markets have become more important as a means of allocating resources. As a result, both banks and non-financial firms find that the number, type, and extent of their exposures have increased significantly. Finally, a spate of volatile financial innovations is simultaneously a source of risk and a means to mitigate it.

Risk management has also received attention because of the repeated and highly publicised firm failures associated with its implementation. Despite the increased academic and professional attention paid to risk management, frequent instances still occur when sophisticated investors or firms experience unexpected, intense, and damaging losses. The infamous cases of Derivatives misuse have amounted in losses of billions of dollars.

One can ask, what are the sources of failures in risk management? If the cause is just extreme bad luck, then it is hard to conclude that the victims are negligent. On the other hand, if such failures occur because of flaws in conceptual approaches or in the way these approaches are implemented, then one can expect such failures to be repeated.

Due to the financial predicament as experienced by many firms, derivatives are often viewed as risky investments that are capable of dragging down even the established corporations. In a survey conducted by the Government Finance Officers Association (1994), it is found that a considerable number of finance professionals believe that the risks associated with derivatives outweighed the benefits. As Richard Graber, senior vice president of the Jones ; Babson Mutual Fund Complex in Kansas City puts it, “Given the choice … the best way to deal with derivatives is to treat them like a crazy relative–stay away” (Welsh, 1995, p. F3). Clearly, for many, derivatives are “more volatile or risky than other financial instruments” (Frankel, 1995, p. 300).

However, first, it is important to clarify the meaning of the term “risky.” Practitioners and authors commonly confuse the distinction between risk and downside risk. “Risk” is the volatility in the price of an investment instrument and not the direction of the fluctuation itself (Frankel, 1995). For every loss resulting from the use of derivatives there is a corresponding gain of an equal amount and vice versa. Although large derivatives losses make the headlines, equally large gains often go unnoticed. In short, if more risks are associated with the investment, there is a greater probability to gain, as well as a greater possible loss (Adams and Runkle, 2000).

Another important issue is risk measurement, which has always been a difficult task. One risk measurement is the usage of the distribution of potential outcomes. However, it is difficult to implement, since estimation of a potential return distribution is usually based on historical data. The availability of such data is often limited, and even when available, older data may have little forecasting value because of institutional or structural changes in the environment. Specifically, in measuring risk through distribution of possible outcomes, it is difficult to estimate the tails of the distribution, since the number of observations in the tails is limited (Kimball, 2000).

With the limitations on the availability of data, the normal distribution becomes the paradigm for risk management. It has one very strong advantage, that is, the probability of any given outcome can be estimated given the mean and standard deviation of the underlying distribution. Another advantage of this measurement is that it allows risk managers to extrapolate the probability of extreme outcomes from relatively few data points. In addition, while it has long been recognised that returns on most assets are not exactly normally distributed, the discrepancy is often so small that many analysts find it convenient to ignore the differences (Kimball, 2000).

However, the assumption of normality in returns is not justified by empirical research, which if applied may result in serious risk-measurement errors. Moreover, many studies such as those of Fama (1965) and Duffie and Pan (1997) have concluded that most asset returns are not normally distributed but instead are fat-tailed and skewed to the left. The use of the normal distribution to estimate frequency of outcomes in such circumstances results in estimates of the frequency of major losses that are too low.

Another risk measurement deals with serial independence. This works on the framework that outcomes are not correlated over time so that the outcome in the next period does not depend on the outcome in this period. In the assumption of serial independence, daily data can be used to estimate weekly, monthly, or annual volatility by multiplying the standard deviation of the daily data by the square root of the number of trading days in the longer period. It also implies that runs of bad luck will always occur but they will be normally distributed.

However, similar to the assumption of normality, empirical evidence does not support the assumption of serial independence in returns (Campbell, Lo, and McKinlay, 1997). Instead, it is found that returns tend to be positively serially correlated, so that an adverse outcome in this period is likely to be followed by an adverse outcome next period (Kimball, 2000). If returns are assumed to be serially independent but actually are positively correlated, then estimates of long-period standard deviations extrapolated from short-period returns will be too low.

The assumptions of normality and serial independence are all examples of model error, which occurs when the potential exposure is recognised but wrongly estimated either because some parameter of the distribution of outcomes or because the correlation between different risks is estimated badly (Kimball, 2000). Model error often results either because managers make inappropriate ex ante assumptions concerning the shape of the distribution or because the conceptual models fail to capture some important aspect of reality. However, a second and extreme form of risk measurement error occurs due to the failure of the firm to recognise any risk exposure, termed “risk ignorance.” It involves the introduction of new products or processes where the technical aspects or environmental effects of such products or processes are not fully understood (Kimball, 2000).

The need for risk management is justified by the existence of capital market imperfections such as taxes and costs of financial distress. Specifically, firms need to address bankruptcy costs, taxes, capital structure and the cost of capital, and compensation packages. A successful risk management increases the value of a firm by reducing the probability of default, reduces taxes by reducing the volatility of earnings, and allows the firm to have a higher debt to equity ratio which is beneficial if debt financing is inexpensive. This consequently allows the firm to expand more aggressively through debt financing and reduces the costs of retaining and recruiting key personnel (Christoffersen, 2002). Derivatives instruments help manage risks that are neither new nor unique, as these risks are found in traditional financial products, i.e  market, credit, legal, and operational risks.

In a 1998 survey on the risk management practices of 2000 companies, it was found that companies use a range of methods and have a variety of reasons for using Derivatives (Christoffersen, 2002). Close to half of the respondents reported that they use derivatives as a risk management tool. In addition, one third of derivative users actively take positions reflecting their market views. Thus it can be seen that they may be using Derivatives to increase risk rather than reduce it. Aside from Derivatives, other financial instruments are used to manage risky cash flows. These include good old-fashioned techniques such as physical storage of goods, cash buffers, and business diversification.

1.6.3    Derivatives

As already defined above, a derivatives instrument is a financial contract whose value depends on the values of one or more underlying assets or indexes.  Derivatives transactions include a wide assortment of financial contracts, including forwards, futures, swaps and options (Adams and Runkle, 2000). Peter Hancock, head of Global Derivatives at J. P. Morgan, stated that, “derivatives…seem to have come to mean anything that lost money” (Muehring, 1995, p. 31).  In a more formal manner, a derivative is defined as a financial instrument, or contract, between two parties that derives its value from some other underlying asset or underlying reference price, interest rate, or index (Backstrand, 1997).

Talking from a risk management viewpoint, derivatives enable firms and government entities to identify, isolate and manage separately the market risks in financial instruments and commodities (Basel Committee on Banking Supervision, 1994). When managed correctly, derivatives can provide efficient and effective means for reducing financing costs and increasing the yield of certain assets. Firms are increasingly relying on derivatives activities as a direct source of revenue through market-making functions, position taking, and risk arbitrage (Basel Committee on Banking Supervision, 1994). Within the market-making functions, firms engage in derivatives transactions and, at the same time, maintain a balanced portfolio with the expectation of earning fees generated by a bid/offer spread. Position-taking is a representation of profit-making efforts by accepting risks stemming from taking outright positions in anticipation of price movements. Similarly, arbitrageurs attempt to take advantage of price movements. However, the focus is to profit from small discrepancies in price among similar instruments in different markets.

A great variety of derivatives exist today. Many are close substitutes for each other in the sense that they are designed to accomplish the same economic goal. Although there are many different types of derivatives, almost all of them fall into one of four major categories (forwards, futures, options, and swaps) that can be further categorised into exchange-traded and over-the-counter (OTC) derivatives. All futures and many options contracts have been standardised and are traded on established exchanges (Romano, 1996), whereas forwards, swaps, and some options, are custom-tailored contracts (Goldman, 1995).

     One can easily be overwhelmed by the apparently countless types of derivative contract traded in the marketplace. The pages of the Wall Street Journal list the prices of tens of thousands of standardised, exchange-traded futures, options and future options contracts on hundreds of underlying assets and this is only scratching the surface. The Wall Street Journal only reports trading summaries for U.S. derivative exchanges. Other exchanges worldwide have derivatives trading volumes roughly equal to that in the United States. Moreover, the notional [A1] amount of exchange-traded derivatives worldwide represents only about 16% of all derivatives outstanding and about 84% of derivatives are private contracts arranged with banks and various financial houses (Whaley 2006). Furthermore, according to Whaley (2006), many of these contracts are plain-vanilla forwards, swaps, caps, collars, or floors, as well as inverse floaters, protected equity notes, ration swaps, time swaps, knockout options, spread locks, wedding-band swaps, and the like.

           Much of the business of the derivatives market is transacted in the UK and the USA. As presented by Swan (2000), the largest share of the business (26.9%) was being transacted in the UK as of April 1995, the daily transaction turnover is reported to be $590 billion, and the trade is approximately earning $5.9 billion in revenue for UK. When using futures to hedge, the risk stems not from potential loss of capital but rather from potential loss of opportunity (Fouque, Papanicolaou & Sircar, 2000).

Derivatives are used mainly for hedging and speculation (Adams and Runkle, 2000). Hedging is a derivatives transaction which is aimed at maintaining the reduction in the risk of economic loss due to changes in the value, yield, price, cash flow or quantity of assets or liabilities; or the risk of economic loss due to changes in the currency exchange rate or the degree of exposure as to assets or liabilities denominated in a foreign currency (Dembeck and Lim, 1999). According to Frederick (1995), hedging is an activity to mitigate economic risk or loss through the use of a counterbalancing or negatively correlated investment. This activity needs an end-user to identify specific business assets subject to price fluctuations and then to purchase derivatives that counteract the effects of a change in the price of those assets, thus ensuring compensating gains for losses caused by underlying market movements (Goldman, 1995). It is therefore important to note that hedging does not aim to increase an investment’s return but is rather intended to make an uncertain outcome less variable.

In a survey by the Group of Thirty (1993), it is found that 82% of the corporations surveyed used derivatives in hedging against market risks resulting from new financing arrangements and 78% used derivatives to modify the characteristics of their existing assets and liabilities. Although a majority of corporations use derivatives to hedge against adverse changes in the value of assets or liabilities, it can be very difficult to find a party on the other side of the market to whom risk can be transferred. Speculation plays an important role in filling this void. Many investors assume the risks of hedgers in an attempt to profit by predicting changes in market rates or prices (GAO Report, 1994). Moreover, advocates of speculation point to its advantage the importance of ensuring adequate liquidity. However, their function is a dangerous one (Adams and Runkle, 2004).

Forward, futures, option and swap contracts are all viewed as derivative contracts because they derive their value from an underlying asset. However, there are some key differences in the workings of these contracts.

A forward contract refers to an agreement between two parties in buying or selling an underlying asset at a specified price and future date (Goldman, 1995). Under this contract, the buyer has an obligation to purchase the underlying asset from the seller at the contract’s maturity date and the seller must sell the asset to the buyer at the agreed-upon price regardless of the current fair market value (Romano, 1996). Speculators use forward contracts based purely on their predictions as to which direction the market will move. On the other hand, to optimise the dollar value of the company’s assets, liabilities and future cash flows, hedgers, firms enter forward contracts with major international financial institutions to stabilise the rates on exchange of foreign currency to the home currency.

Likewise, futures contracts involve parties contracting for the exchange of a specific asset at a future date (GAO report, 1994). The major difference is that futures contracts are standardised and must be traded on an organised exchange that provides a central location where buyers and sellers of standardised contracts trade. Wit standardisation, it is significantly easier for a trader to close out a futures position than a forward position (Eatwell, Milgate, and Newman, 1998). Moreover, the primary objective for using futures contracts, like forward contracts, is to reduce the risk through hedging (Adams and Runkle, 2000). However, hedging provides gains to only one party at the expense of the other: – if the price of the underlying asset increases after the agreement is made, the buyer gains at the expense of the seller; if the price of the asset drops, the seller gains at the expense of the buyer (Leonard N. Stern School of Business, 2004).

Futures contracts are also employed in speculation using the same methods used in the forward markets. According to Romano (1996), speculating in the futures market is more convenient than in the forward markets because of the “unique offsetting feature,” enabling investors to avoid taking possession of the underlying asset at the delivery date (p. 32). For example, in using petroleum futures exchanges Texaco “reduce[s] the company’s exposure to price volatility by establishing margins, costs or revenues on designated transactions as well as for planned future purchases and sales, inventory, production and processing” (Texaco Inc., 1997, p. 66).

Another type of derivatives instruments is the options contract, which is similar to both futures and forwards in that each instrument derives its value from the future price of the underlying asset. In addition, these types of contracts involve the future purchase or sale of an asset for a predetermined price (Frederick, 1995). The difference, however, is that options contracts provide the option holder the right, but not the obligation to perform a specified transaction with another party.

One major benefit of an options contract over other types of derivative instruments is its capacity to mitigate downside risks without foregoing upside potential (Adams and Runkle, 2000). This is possible because the loss is limited to the amount of the premium paid to the option writer, whereas the gain remains unlimited (Romano, 1996). In addition, the unique features of options contracts provide holders with the ability to benefit from increased variance in the performance of the underlying asset (Romano, 1996).

When used for hedging, options contracts have significant benefits in addressing price risk. However, hedging with options is more difficult compared to hedging with futures contracts. This is due to the option holder’s right to walk away from the transaction with a loss limited to the premium paid (Romano, 1996). On the other hand, speculation with options is more advantageous than with futures and forward contracts, reducing the downside risk to the price of the premium paid. With this, speculators can take riskier positions without being responsible for the extent of the potential loss.

The fourth type of derivatives instruments is the swap, which refers to OTC agreements between two parties to exchange a series of cash flows (Romano, 1996). A common type of this agreement is an interest rate swap. “In a fixed-for-floating rate swap, the simplest interest rate swap, one counterparty agrees to make fixed-rate payments to the other counterparty, who [in return] agrees to make floating-rate payments” (Romano, 1996, p. 47). This type of interest rate swap reduces the effect of interest rate volatility faced by both parties (Frederick, 1995). Moreover, because of the reduced positive and negative effects of interest rate movements, fixed-for-floating rate swap is utilised primarily to make a better prediction of interest rate sensitive investments.

Compared with futures contracts, swaps are more beneficial because of the fact that they may be carried out OTC and thus are not constrained by the standardisation requirements imposed on the futures market. Regarding hedging, swaps are most effective when the investor is a financial institution because these often possess “mismatched asset and liability” time frames (Romano, 1996, p. 65). As financial institutions lend at fixed rates for the long term, but borrow at floating rates over the short, they are vulnerable to money loss if short-term rates rise. With these benefits, many companies enter into swap contracts. As an example, PepsiCo uses swap agreements to reduce borrowing costs and the interest rate swaps enable the company to change the interest rate of specific debt issuances.

1.6.4    Risks in Derivatives

Prior to the 1990s, knowledge about derivatives was not common outside the most sophisticated investment circles (Adams and Runkle, 2000). These are, in fact, publicly highlighted in the 1990s and this led to two different schools of perspective. On the one hand, investors who are victims of extreme financial loss and bankruptcy view derivatives as destructive instruments, similar to the intensity caused by a herd of stampeding buffalos. Here, it seems that avoidance is the best solution. On the other hand, enlightened investors associate derivatives to a team of horses, which when harnessed and used appropriately become productive, effective and efficient tools, maximizing resources and reducing risk.

In the US, approximately 75% of the largest companies use derivatives instruments (Holland and Schiller, 1994). According to the United States General Accounting Office (GAO) (1994), the surge in derivative use within the past two decades is a result of fundamental changes in global financial markets, leading to increased demand for cost-effective protection against the risks known to result from movements in foreign exchange rates, interest rates, equities, and commodity prices. The Group of Thirty reported that 94% of Fortune 500 CEOs are satisfied with their firm’s use of derivatives.

The trouble with the misuse of derivatives begins when unforeseen market changes require one party to the contract to post large amounts of cash quickly to cover collateral obligations. There are some infamous cases in which the use of derivatives has been involved with large-scale financial failures. Oppositions to derivatives point to the widespread financial losses and bankruptcy during the 1990s. In fact, from 1983 to 1993, the total reported monetary loss associated with derivatives is estimated to be about $2.1 billion, and in 1994, this loss skyrocketed to $10 billion (Muehring, 1995). Apart from those labelled above, some of the most notable publicly reported or acknowledged derivatives losses include: Gibson Greetings; Proctor ; Gamble; MG Corp., the U.S. subsidiary of Germany’s Metallgesellschaft AG; Dell Computer; Atlantic Richfield Co.; Merrell Dow Inc.; Mead Corp.; Paramount Communications; Caterpillar Financial Services Unit; City Colleges of Chicago; Odessa College; Escambia County, Florida; and Wisconsin’s investment fund (Leckey, 1994).

The cases of Barings PLC in Great Britain and Orange County are two of the most publicised derivatives catastrophes that ended in bankruptcy. Barings PLC loss of an estimate $1 billion was associated with derivatives (Stevenson, 1995), whereas Orange County, lost almost $2 billion as a result of derivative misuse (Brown, 1994). Firm failures attributed to derivatives also extend from Western to Asian firms. In fact, derivatives are highlighted during the 1998 Asian currency crisis, specifically in South Korea (O’Brien, 1998a). In its lawsuit against a large South Korean bank and a South Korean investment firm, J.P. Morgan ; Co. sued the latter for their inability to fulfil obligations on swap contracts relating to exchange of US dollars for some Southeast Asian currencies (Frank, 1998). SK Securities countered the lawsuit stating that J.P. Morgan in Korea failed to adequately inform them about the risks brought about by derivatives transactions.

Moreover, the steep devaluation of the Russian ruble in Mid-August of 1998 is another case which shook investors’ confidence in the foreign market and the use of derivatives (Newsday, 1998). Though most American banks could absorb the losses of the ruble devaluation, some have experienced severe losses. The Republic New York Corporation reported losses in Russia equal to its total third-quarter earnings for 1998 (O’Brien, 1998b).

The publicised firm failures have raised questions as to whether derivatives are riskier than other investments. Taking off from a portfolio perspective, derivatives reduce rather than increase risk because they are used most often to hedge existing portfolio risk (Frankel, 1995). Others argue that it is the speculative impulse of investors that creates risk not derivatives. Furthermore, many say that derivatives are less risky than other types of investment instruments (Muehring, 1995). In support for derivatives, a managing director at Bankers Trust said, “People lost a lot more money in the two-year Treasury note than they ever did in derivatives” (Muehring, 1995, p. 32). So there is a wide perception that derivatives are not riskier than any other investments. Derivatives can neither create nor destroy risk; they can only transfer existing risk from one investor to another (Adams and Runkle, 2000).

The negative perception on derivatives is a result of confusion due to complexities associated with most derivative transactions (Frankel, 1995). The complexity of derivatives is attributed to many factors. One of these is the customisation of many of the derivatives to the needs of the individual investor and the other is the failure to test derivatives outside the confines of a hypothetical model. Moreover, statements and recommendations made by brokers can both inadvertently and intentionally mislead investors (a result of an ironic relationship that can possibly develop between brokers and investors) (Adams and Runkle, 2000). Other factors that contribute to the complexity of derivatives include confusing documentation, faulty disclosure of risks, and underdeveloped accounting considerations (Manning, 1995). Each of these deficiencies adds to the other obstacles, such as valuation difficulty and risk determination (Baird et al., 1995). These complexities are amplified by inadequate internal management controls (Adams and Runkle, 2000).

The already complex nature of most derivatives is made more complicated by the use of deficient risk measurement mechanisms, inadequate risk management controls, and  poor understanding of the significant role of derivatives in investment strategies. This confusion often results from a mixture of these factors that leads to the misuse of derivatives, and eventually, in damaging losses. The most complicated derivatives tend to be customised OTC derivatives, which frequently consist of a combination of several derivatives that are often hypersensitive to changes in the underlying market (Knap, 1994).

1.6.5    Proper Use of Derivatives

Risk management initiatives proposing recommendations for safe and effective derivatives use have evolved. All of these proposed initiatives put an emphasis on management controls (Adams and Runkle, 2000). As Leslie Rahl, a principal in a financial consulting firm in New York, stated, “It’s not derivatives causing the problem, but a lack of management controls, and process” (Bencivenga, 1994: 5).

One example of an initiative targeting management control is the recommendations of the Group of Thirty (1993) directed at the OTC derivatives market. These recommendations are beneficial for corporations as well and many market participants have incorporated them into their own internal policies and procedures. The Group of Thirty (1993) proposes a four-step management control system process for safe derivative use. This recommendation involves education, policy, implementation, and control.

The first step for sound and effective derivatives use is corporate education. Top management must ensure a proper education for those who are responsible for anything related to derivatives (Blanc, 1995). What is needed is an informed and knowledgeable investor who best understands how and when to use derivatives and the firm’s exposure to risk. In corporate education, one must have knowledge about the types of derivatives that are available, how each function within a particular investment strategy, the advantages and disadvantages of each and knowledge of the firm’s tolerance to loss (Adams aand Runkle, 2000). This first phase should be completed for the objectives and directives of the second phase to be meaningful.

The next step for safe derivatives use is the setting of a corporate derivatives policy. To prevent the misuse of derivatives, a policy should be instituted with the active participation of the board of directors and senior management. A clear and concise risk management policy should explain the purpose for the use of derivatives and include the extent to which derivatives will be used in pursuit of the overall business objectives (Blanc, 1995). The risk management policy should also establish specific and consistent risk management expectations by setting limits to market and credit risk exposure. Guidelines are also needed to minimise legal and liquidity risk. Finally, these policies should be communicated unambiguously and distributed in writing to those involved in any of the phases of the Group of Thirty’s proposed management control system.

When a corporate derivatives policy has been set, the next step involves the implementation of an investment strategy with an overall purpose of helping a corporation meet the goals established in the derivatives policy. The general rule should be to use derivatives as a means of shifting risk and not as a means of trading in risk. Specifically, the Group of Thirty (1993) recommends that: derivative use should correspond in quantity, complexity, and risk with the objectives of the corporation; unnecessary risk should be avoided in the areas of speculation and leveraging (this magnifies the risk of a transaction); derivatives should be used almost exclusively for hedging and investors should adjust exposures to risk rather than use derivatives to increase expected short term profits.

Other recommendations include: the avoidance of the use of derivatives that are extremely complex; the need for personnel who are highly qualified, appropriately trained and informed of the firm’s investment strategy and tolerance for loss; and the clear indication by the senior management of the lines of decision-making authority and keeping senior management informed of the current derivatives investment status through timely derivatives activities reports. In implementing these strategies, the active participation of the board of directors and senior management must be sought and the implementation must be consistent with the board’s authorisation.

The last step in the Group of Thirty’s proposed management control system involves the establishment and maintenance of a key set of internal controls. In this control phase, those involved in derivatives transactions must make sure that all of these transactions are authorised and in accordance with the policies and strategies that have been enacted, and that any deviations from these standards are reported (Adams and Runkle, 1997). Investors can accomplish this control mechanism through a valuation procedure that incorporates all of the relevant risk factors and produces a model of possible outcomes that are compared with actual performance (Nusbaum, 1995).

The Group of Thirty also recommends that all of the analysed risk exposures be quantified using ranges and relative probabilities; all derivatives positions and risk exposures be monitored frequently and regularly by well-qualified and knowledgeable people; and that derivatives transactions be collected and disbursed through a system of checks and balances. Moreover, GAO (1994) recommends that traders with customer contact, as well as administrative staff with accounting and operations responsibility should provide a desirable check on each other as long as each is independent of unwanted influences and each other.

1.6.6    Minimising Risk Exposure

The control management system proposed and recommended by the Group of Thirty helps investors minimise risks associated with derivatives (market risk, credit risk, legal risk, liquidity or systemic risk and operational risk).

Market risk is the exposure to the possibility of financial loss caused by adverse changes in the values of assets or liabilities in all investments (GAO, 1994). Market risk refers to fluctuations in the price of a financial instrument (Simons, 1995). It results when some market-determined asset price, reference rate, or index is changed. Market risk can be classified according to the type of event that generates it. On the one hand, market risk is defined based on the type of asset class whose price changes affect the exposure. On the other hand, the market risk of an exposure can also be characterised based on how those risk factors impact its value.

Dealing with market risk is a difficult task. The complexity of managing this lies in its measurement, which is dependent upon an accurate valuation of the instrument affected by many factors. The assessment of market risk of derivatives depends on the valuation of underlying instruments (Simons, 1995). According to the GAO (1994) report, “accurately measuring the market risk for derivatives portfolios requires the use of modern computer systems and software that rely on the most advanced mathematical, statistical, and database techniques” (p. 60). Utilizing the value-at-risk methodology, the amount predicted to be lost from an adverse market movement are compared to market risk limits that have been agreed upon by senior management and the board of directors, thereby evaluating the current derivatives strategy (Adams and Runkle, 2000).

Using the value-at-risk methodology also aids the investor in implementing an appropriate hedging strategy to minimise these excessive market risks. However, although this method is helpful for monitoring daily market risk exposure, it does not provide an accurate representation of the maximum potential loss. Therefore stress tests should be conducted in measuring market risk.

Market risk of derivatives must be evaluated on a portfolio basis (Simons, 1995). For example, an institution may hold a derivative contract to minimise the market risk of a specific asset or liability. Thus, the market risk of a derivative instrument to the institution is not measured by the price fluctuations of that individual contract. Rather, the more important issue is whether or not the instrument reduces the overall market risk of the institution’s portfolio (Simons, 1995).

Credit risk is another principal risk. It is the threat of the actual or probable non-performance by a firm. It carries with it the possibility that loss will occur when the counterparty defaults on a derivative contract (Simons, 1995). For example, counterparty will not have sufficient resources to meet the obligations contained in the contract and thus will default. Similar to market risk, to deal with credit is never an easy task because in managing this type of risk the rapidly changing extent of exposure has to be considered (GAO, 1994). In order to minimise and control credit risk, investors must fully and accurately measure credit risk that is associated with the derivatives. The Group of Thirty recommends that an investor should compute both the current level of credit risk exposure and the potential level of credit risk exposure since it fluctuates over time with the value of the contract.

Current exposure is the cost of replacing the transaction if the counterparty defaults today. Potential exposure, on the other hand, is the potential replacement cost if the counterparty defaults in the future (Simons, 1995). The intensity of credit risk is greater with OTC derivatives contracts than with exchange-traded ones. The reason is that exchanges reduce credit risk because they require both buyers and sellers to post margin collateral. The contracts are marked to market and margin requirements are settled on a daily basis. On the contrary, OTC derivatives contracts are not settled for relatively long periods of time, usually are not collateralised, and are not subject to clearing house offset, which makes them less liquid and increases credit risk (Simons, 1995).

Exposure to credit risk can be minimised by establishing limits on the amount of exposure for each counterparty individually and avoid concentrating derivatives transactions with a single counterparty. In addition, investors can enter into bilateral netting agreements, or consider using credit enhancements, such as collateral, guarantees, and letters of credit.

Legal risk results because a contract cannot be enforced. This risk of loss may arise due to uncertain legality of contracts in bankruptcy. Here, the possibility of financial loss results from an action by a court, a regulatory entity, or a legislative body that invalidates a financial contract. Legal risk is also a result of the lack of authority of the counterparty to enter into the transaction (Simons, 1995). This usually occurs in the context of a broker entering into an agreement with a government entity that is not authorised to enter into the contract (Adams and Runkle, 2000). Furthermore, unexpected changes in laws and regulations can also expose firms to potential losses.

Setting limits to the extent of allowable exposure and taking action to conform to those limits are not applicable in managing legal risk. Exposure to legal risk can be minimised most effectively by adopting best practices guidelines which involves researching the legal status of current derivatives and the authority of the counterparty to enter into transactions.

Another risk that needs to be minimised is liquidity risk. Liquidity risk occurs when cash inflows and current balances are insufficient to cover cash outflow requirements, often necessitating costly asset liquidation to generate temporary cash inflows. Managing this type of risk makes risk management more difficult and expensive (Simons, 1995).

Liquidity risk is classified into two. It includes a type of risk called market liquidity risk or systemic risk. Market liquidity risk occurs where  volatile markets will inhibit the liquidation of losing transactions and/or the establishment of new transactions to hedge existing market risk exposures. In this type of risk, disruptions in the market or the lack of available positions prevent an investor from offsetting a current position with a competitively priced derivatives transaction at the appropriate time. The second type of liquidity risk is funding liquidity risk. It is the risk that mismatched durations of in flowing and out flowing funds leads to an investor’s inability to meet payment obligations. Most financial and non-financial firms have liquidity plans designed to manage funding risks.

There is not much that investors can do to eliminate market liquidity risk due to the continuing liquidity requirements in both the underlying market and the derivatives market. They can only manage by understanding the derivatives market and the market of the underlying asset (Adams and Runkle, 2000). Managing market liquidity risk through this understanding can be accomplished by working with other market participants and regulators, which will help the investor recognise what indications exist to warn of ensuing liquidity difficulties. This enables appropriate actions to be taken prior to the inaccessibility of the market. On the other hand, investors can best manage funding liquidity by identifying mismatched payment and delivery obligations and implementing models that characterise the effects of market changes on these cash flows.

Another risk, operational risk is the possibility of financial loss resulting from inadequate systems and internal controls, human error, management failure, or irresponsible trading activities by employees. This may also include failures in computer systems, internal supervision and control, or events such as natural disasters. In these cases, the problems tend to arise because inadequate attention is paid to some process or system or because personnel either fail to perform their duties or have ill-specified responsibilities. Although operational risk exists with all securities, with derivatives this is increased because of their complexity. The cost of mistakes can also be higher than with traditional securities owing to greater volatility of some derivative positions (Simon, 1995).

The management control system recommended by the Group of Thirty can minimise operational risk. As previously discussed, the investor can go through a four-step process to reduce operational risk: (1) education of employees, (2) establishment of clear investment policies, (3) implementation of investment strategies that achieve the objectives of the company while following the set policies, and (4) an independent control system that continually monitors and reports derivatives performance, risk exposure, and the effectiveness of the investment strategies.

1.7  Hypothesis

Consistent with the findings supporting derivatives use and misuse, this dissertation hypothesises that the users’ and controllers’ lack of knowledge, expertise and uneasiness on/with derivatives, rather than the  derivatives per se[A2] , has lead them to make unprofitable decisions which led to the collapse or large losses of companies.

1.8  Conceptual Framework

Figure 1. Conceptual Framework of the Study

Evaluation of Use and Misuse of Derivative
Use, Knowledge and Expertise of users and controllers
Projected Impact of Derivatives use
1.     Risk  Management

2.     Reduce Costs

3.     Increase Yield

Measuring Level of:

1. Unease in the Use of Derivative

2. Knowledge of Managers on Derivative

3. Level of Derivative Expertise of Managers

Disparity in the Projected and Actual Impact of Derivative
Impact of use and misuse of derivative on Barings Bank, MG, AIB, Enron, LTCM, Amaranth, Italease Bank ; Societe General.

The figure above shows the conceptual framework of the study. On the one hand, the research evaluates the projected impact of use and misuse of derivatives on the cases of Barings Bank, MG, AIB, Enron, LTCM, Amaranth, Italease Bank and Societe General.  In this category, three factors are examined: (1) use of derivatives as an instrument in risk management; (2) use of derivatives to reduce financing cost; and (3) the use of derivatives to increase the yield of certain assets.  On the other hand, the research study also evaluates the factors of knowledge and expertise of users and controllers using three variables: (1) level of unease or easiness of the use of derivatives; (2) knowledge of managers on use of derivatives; (3) level of expertise in using derivatives in the companies. This is examined in order to derive the disparity between the two (projected and actual impact of use of derivatives) and help understand what went wrong.

1.9  Significance of the Study

This dissertation provides insights on uses and misuses of derivatives and the causes of firm failures/losses. It contributes to the increasing body of literature which proves that firm failures attributed to derivatives only happen when derivatives are placed in the hands of inexperienced investors with inadequate control or training. Moreover, this study breaks the myth surrounding derivatives and firm failures by stating that derivatives are an essential corporate tool when properly used to hedge against risk. Since the derivatives myths still condition the minds of management and corporate directors, a further study needs to be conducted to educate them on how derivatives could protect their corporation. This study should be focused on setting clear risk management policies and identifies if and how derivatives can be used to ensure that they will be beneficial to managers and directors.

1.10 Definition of Terms

     The following terms are used in the study:

Asset Class — A broadly defined group of securities that have similar risk and return characteristics.  Examples of asset class categories include: equities, fixed income, cash, etc.

Benchmark — A standard against which risk and return investment performance can be evaluated.  Different benchmarks are used for evaluating different asset classes or styles of investing.

Counterparty risk — The exposure of one party to the risk that a trade might default or fail due to the actions of the other party to the transaction.

Credit Risk — The risk of loss from not receiving one’s reward for being on the right side of a bet about a market movement. This is due to the losing counterparty’s failure to meet his obligations.

Derivatives — Broadly defined, a derivatives instrument is a financial contract whose value depends on the values of one or more underlying assets or indexes. Derivatives transactions include a wide assortment of financial contracts, including forwards, futures, swaps and options

Forward Contract — A contract to exchange an underlying instrument for a fixed forward price at a specific future delivery date.

Futures Contract — An exchange-traded contract that on its last trading day settles into a forward contract; it is an agreement to buy or sell a specific amount of a commodity or financial instrument at a particular price on a stipulated future date.

Hedging — A strategy designed to reduce investment risk or help lock in existing profits, aiming to reduce the potential volatility of a portfolio, by reducing the risk of loss.

Legal Risk — The risk of loss that arises due to uncertain legality of contracts or the lack of authority of the counterparty to enter into the transaction.

Leverage — The practice of borrowing to add to an investment position when one believes that the return from the position will exceed the cost of borrowed funds.  Leverage can have the effect of magnifying returns as well as losses.

Liquidity — The ease of converting an invested asset to cash or liquid capital.

Liquidity risk — It is the possibility that a disruption in one market will cause further disruption in other markets.

Mark to Market – When securities are sold short, these are placed in a short account within a general margin account. This is an accounting procedure required for maintaining the credit balance in the short account equal to the market value of the short positions.

Market Risk — The risk of loss from being on the wrong side of a bet about a market movement.

Operational risk — It is the possibility of financial loss resulting from inadequate systems and internal controls, human error, management failure, or irresponsible trading activities by employees.

Option — A financial contract giving the owner the right, but not the obligation, to buy or sell a fixed amount of a given asset at a specific price within or by a specified period of time.

Over-the-country derivatives ­- Derivatives that are transacted “over-the-counter” through dealers and not through organized exchanges.

Portfolio insurance — A strategy employing combinations of securities, options, and/or futures contracts that are designed to provide a minimum or floor value of the portfolio at some future date.

Risk — Exposure to uncertain change, upside or downside.

Short — A term used to refer to holding a short position or to the party holding the short position. A short position involves a firm who has sold a futures contract or owes the asset to someone for future delivery.

Swap — The exchange of a sequence of cash flows that is derived from two different financial instruments.

Value — An investment strategy that is based on acquiring out of favour securities whose prices do not yet reflect the companies’ intrinsic value and/or are “under followed” by analysts. Normally is an asset, cash flow, book value based.[A3]

Volatility — Is the measure of the degree of dispersion of returns around the mean and is one of the several investment risks.  Standard deviation is used as a statistical measure of this.

1.11 Dissertation Outline

This introductory chapter presents the statement of the problem, an overview of the study, the significance of the study, states the rationale and the scope of the study, and describes in detail what the dissertation has set out to demonstrate. In this chapter, characteristics of derivatives are discussed. A more detailed discussion follows in the next chapter. This dissertation suggests that derivatives are not the reasons why companies fail or make losses, but rather, it is the people who manage it that misdirect the company including their handling of derivatives.

The second chapter provides an extensive and critical presentation and analysis of the research that has already been done on Derivatives. This review of related literature is divided into five sections. The first part is the introduction to derivatives, what are derivatives, how and why are derivatives used?, and the major types of derivatives. The second section deals mainly with risks: what does risky mean?, how risky are derivatives?, how can risk be measured?, the question of whether derivatives are riskier than other investments, complexity of derivatives, and misuse of derivatives.

The third part of the second chapter discusses the new conceptualisations of derivatives use, regulatory structure that is applicable to derivatives, corporate liability for not using derivatives and fiduciary duty to affirmatively use them, and measuring shareholder losses brought about by not using derivatives. The next section addresses the question on the safe usage of derivatives, the use of a management control system, and management of risk. Finally, the future outlook on derivatives is discussed.

The third chapter discusses in detail the research methodology to be used. This study utilises both a survey/interviews and a case study methodology with descriptive design. Barings Bank, Metallgesellschaft AG, Allied Irish Bank, Enron, the LTCM Hedge Fund, Amaranth Advisors LLC, Italease Bank and Societe General are treated as separate case studies and are evaluated comprehensively and thoroughly. The descriptive method are used for the purpose of gathering information.  The research described in this study will be based fundamentally on qualitative and quantitative research methods.

In the fourth chapter, results of interviews, surveys and case studies are analysed and interpreted.  Figures and tables are used to provide further clarity for the surveys and interviews.

Finally, the fifth chapter summarises the discussions and recommendations, gives the results, presents any significant findings, and draws conclusions. It is hoped that in this chapter, derivatives would be put into the limelight and consequently debunks the myths about uses and misuses of derivatives.

1.12 Summary

This dissertation contends that derivatives only cause firms severe losses when investors are not properly educated about the nature of derivatives, when senior management and those involved in derivatives transactions fail to actively participate in instituting corporate derivatives policies, when the firm fails to meet the goals established in the derivatives policy, and when it fails to establish and maintain a key set of internal controls.

This chapter has discussed the issues surrounding derivatives, mainly on the misuse of these instruments. It has been indicated that the use of derivatives among both financial and non-financial institutions is widespread and growing. Likewise, many of these firms use it responsibly and employ adequate risk management systems. However, it is obvious that not all firms are immune to derivatives misuse. Barings Bank, MG, AIB, Enron, Amaranth, Italease Bank and Societe General amongst others.


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[A1]is this national or national? kindly check and make changes accordingly.
[A2]as you have noticed, i have omitted the phrase “use of.” I went back to the earlier statemens you made about attributing the failures to the use of derivatives. I see that in the beginning, you are pointing to the misuse and the people behind the use of it are the factors that lead to its failure. You are trying to divert the attention of readers away from blaming the instrument per se. But here, you are actually diverting it too from the misuse when you put “use of.” Thus, we have to omit this here.
[A3]Kindly check this whether the sentence is appropriate.


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