How Hedging Goes Wrong
Ashanti: Unexpected cash calls
Ashanti Goldfields was one of the world's largest gold mining companies. To cope with low gold prices in the 1990's, it sold forward production using complex derivative products. When prices rose suddenly in 1999, significant cash become payable on margin calls, which Ashanti couldn't pay. Collapse was only avoided by negotiating ‘payment holidays' on the margin calls at the expense of giving warrants that diluted shareholder equity.
Failures: Failure to plan for the cashflow requirements of margin calls – hedging contracts should have been structured to avoid requirements to pay margin calls. Use of exotic options which increased committed ozs when $ prices rose.
Result: Near collapse and major restructuring required in 2000, with loss of shareholder capital.
Barings: Catastrophic Failure to Control Open Positions
A single trader, Nick Leeson, was authorised by Barings to trade for clients and make low risk arbitrage trades. Leeson abused this authority, and took a speculative futures position betting on movements on the Japanese stock market and government bonds. As the markets continued to move against him, ever larger trades were made in an attempt to recover losses, until the losses became unsustainable.
Failures: Barings risk management controls failed to monitor adequately the unauthorised trading of an employee or the positions held by the bank. Senior management lacked understanding of the risks of highly geared derivatives positions. A single trader had control of front office and back office procedures, allowing losses to be hidden.
Result: Losses from a speculative position developed that were so large as to be beyond the financial resources of the bank. This led to the widely publicised collapse of Britain's oldest merchant bank in Feb 1995 after it couldn't meet margin calls required by the Singapore Mercantile Exchange (SIMEX) Sumitomo: Failed attempt to manipulate market
A single trader employed by Sumitomo, Yasuo Hamanaka, built large speculative long positions in Copper. He effectively controlled a sufficient part of the world's copper supply to affect the copper price, keeping it artificially high. Whilst this initially resulted in significant gains, when the positions became unsustainable, there were sharp falls in copper prices and losses in excess of $1.8 bn resulted.
Failures: Either by possible invlvement by senior management or through lack of monitoring, there was unlawful manipulation of the copper price, which could only be sustained by holding large speculative positions.
Result: Significant losses for Sumitomo and prison for Mr Hamanaka
Natwest Markets: Misvalued Derivative Positions
In 1997, Natwest Markets discovered a loss initially reported at £50m, that rose to £90m on its interest rate derivatives trading books. Traders had misvalued positions, demonstrating that even standard traded options can be complex to value, and internal management had possibly been involved in hiding subsequent losses.
Failures: Procedures for pricing options positions, i.e. pricing models failed. Failure to adequately supervise and monitor positions.
Result: Fines and criticism from the regulators. A fall in market capitalisation in excess of the immediate losses related to the failure, due to loss of confidence in management.
Conclusions
Very significant movements in market price for all types of commodity have tested risk models to their limits – scenarios previously deemed too unlikely to be considered have actually occurred. Although hedging problems are often accompanied by other management or strategic errors, when problems do occur, they can be serious enough to bring down large companies.
For financial institutions used to large volumes of derivative transactions, large speculative positions can easily be entered into without management authorisation. Controls must be sufficient to identify all trading on the firms account, for example by clear separation of front and back office roles, and senior management need to be aware of open positions and competent to review their potentially complex nature. Reputational damage from risk
management failures can exceed any immediate financial loss.
The importance of effective risk management controls and procedures cannot be
overstated. |
