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In recent years there has been revolutionary change in the financial marketplace. The very same
marketplace that traditionally facilitated the transfer of funds from investors to firms has brought forth
numerous derivative instruments that facilitate the transfer of risk. Just as the financial marketplace
has been innovative in engineering various types of investment contracts, such as stocks, bonds,
preferred stock, and convertible bonds, the financial marketplace now engineers risk transfer
instruments, such as forwards, futures, options, swaps, and a multitude of variants of these derivatives.
Reading stories about derivatives in the popular press might lead one to believe that derivative
instruments are dangerous and destabilizing—evil creatures that emerged from the dark recesses of the
financial marketplace. Time magazine once introduced a cover story about derivatives with a caption
“High-tech supernerds are playing dangerous games with your money.” 2 The use of derivatives has
been implicated in many of the financial calamities over the past two decades: the bankruptcy of
Lehman Brothers, the demise of Bear Stearns, the collapse of Barings Bank, and devastating losses
suffered by Procter & Gamble, Metallgesellschaft, Askin Capital Management, Orange County
(California), Union Bank of Switzerland, and Long-Term Capital Management. In each of the cases,
vast sums of money quickly vanished, and derivatives seemed to be to blame.
What Went Wrong: Case Studies of Derivatives Debacles
Derivatives were not solely responsible for the financial calamities of the 1990s and 2000s. Greed,
speculation, and probably incompetence were. But just as derivatives facilitate risk management, they
facilitate greed and accelerate the consequences of speculation and incompetence. For example,
consider the following case histories and then draw your own conclusions.
Barings Bank
On February 26, 1995, Baring PLC, Britain‟s oldest merchant bank and one of the most venerable
financial institutions in the world, collapsed. Did this failure follow years of poor management and
bad investments? Hardly. All of the bank‟s $615 million of capital had been wiped out in less than
four months by one employee halfway around the world from London. It seems that a Barings
derivatives trader named Nicholas Leeson, stationed in Singapore, had taken huge positions in futures
and options on Japanese stocks. Leeson‟s job was supposed to be index arbitrage, meaning that he was
supposed to take low-risk positions exploiting discrepancies between the prices of futures contracts
traded in both Singapore and Osaka. Leeson‟s job was to buy whichever contract was cheaper and sell
the one that was more dear. The difference would be profit for Barings. When he was long in Japanese
stock futures in Osaka, he was supposed to be short in Japanese stock futures in Singapore, and vice
versa. Such positions are inherently hedged. If the Singapore futures lost money, the Japanese futures
would make money, so little money, if any, could be lost.
Apparently, Leeson grew impatient taking hedged positions. He began to take unhedged bets,
selling both call options and put options on Japanese stocks. Such a strategy, consisting of writing call
options and writing put options, is called a straddle. If the underlying stock price stays the same or
does not move much, the writer keeps all the option premium and profits handsomely. If, in contrast,
the underlying stock price either rises or falls substantially, the writer is vulnerable to large losses.