Opportunities and Risks in the Derivatives Markets

SWAPS: The Case of Procter and Gamble

Case Summary

P&G announced a pretax adjustment figure amounting to $152m on its income. The adjustment related to a loss of two innocuous interest rate swaps with Banker’s Trust. The arrangement was designed to reduce P&G’s financing costs. The small amount of $152 million should not have impacted the company and the industry were it not for the underlying reasons (Jacque, 2010). After all, P&G has amassed net income of $2.2 billion in the fiscal year underlining its strong performance across different portfolio. The company filed a lawsuit against Bank Trust alleging manipulation that resulted into the loss of the said amount. The case was eventually settled out of court allowing P&G reduced amount from $152m to 35.

P&G wanted to take advantage of the lower rates compared to its fixed debt of 5% that it had borrowed previously. The company deemed it financially beneficial to negotiate financing that would exploit the lower interest rates that were applicable to a Commercial Paper. P&G was able to secure favorable financing terms at 75 basis points below the commercial paper rates. This was an attractive offer but which also came with significant risk (Jacque, 2010). The company was informed that it could end up with a more costly debt if the interest rates increased over the contract period. The arrangement was therefore beneficial to P&G if the interest rates remain the same or fell further down over the contract period. Unfortunately for P&G, the interest rates rose and imposed further financing costs on P&G.

Treasury as Cost/Profit Center

The approach adopted by P&G’s treasury could be considered as a cost center. Ordinarily, a company’s treasury performs the function of raising the capital of the company and hedging the risk or exposure. In the first case, the objective of raising capital is to ensure that the cost that is represented by interest rates is reasonable and lowest possible (Jacque, 2010). This parameters allow the company to pay minimal interest costs over the period of the debt. It would therefore reduce the overall organizational expense related to financing its operations. In the second instance, the aim is to minimize the risk of exposure that the company may be entering when striking the deals (Sundaram, 2012).   P&G was most concerned about reducing the overall cost of its debt while forgetting to address the likely impact on the revenues. By emphasizing cost over all other factors, P&G’s treasury was defined as a cost center. For the treasury to qualify as a Profit Center, it would have been preferable to define parameters that allow for revenue generation while also limiting the cost. Hedging against the risks should be considered as important as reducing the cost of finance during the negotiation.

Suitability of Interest Swaps

Interest swaps could be a powerful tool for reducing the overall cost of debt for a company. It is most applicable when the company wants to take advantage of current or projected economic conditions than those within which a company could have entered into some financing arrangements in the past (Li et al., 2017). For example, P&G had an ongoing fixed debt whose rate was not responsive to lower interest rates prevailing in the market.  An interest swap means that the company can renegotiate the interest rates and take advantage of the lower interest rates. However, the interest rates must remain at the same rate of reduce further for a swap to be beneficial for the company.

Volatility of Basing Swap Outcomes on Interest Rates

The formula preferred by Bank Trust was sensitive to the changes in the interest rate. It is highly volatile and risky to base any outcome on the interest rates. This is in part because the interest rates are affected by several factors beyond the control of the company (Jacque, 2010). However, basing the outcomes of the contract on the yield and prices is more predictable because they are controllable factors across the involved parties. One of the striking elements in the outcome of the case is that the case was settled out of the case.

Application of Fiduciary Responsibility

This approach is best in resolving trade conflict because it is not fraught with rules and limitations imposed by the courts. However, the fiduciary responsibility requires brokers or agents to give its clients advise that serve their best interest rather than merely supporting the objective of the investor. The judge should therefore have ruled on this principle and hopefully strike out the $152million obligation imposed on P&G (Sundaram, 2012). It is evident from the complicated formula used by Bank Trust agents that their motive was not on offering P&G best outcomes but only that which satisfied the bank’s interest. P&G should have hedged against its exposure by swapping its existing debt with a variety of portfolios rather than the Commercial Paper only.

Amaranth: Speculating in Natural Gas Futures

Case Summary

Hedge funds are known for delivering high-profit margins in the financial and capital markets. However, they also pose one of the most significant risks for investors. This is in part because they are not strictly regulated compared with other investment portfolios. A case in point is that of Amaranth Advisors LLC, a hedge fund investment group that collapsed in 2006 after losing an estimated $5billion over a period of 3 weeks (Jacque, 2010). Amaranth was a hedge fund headquartered in Connecticut. At its peak, the company had $9 billion in assets. However, a loss of $5 billion in natural gas futures represented the largest in the industry and propelled the firm toward its demise.

The company began its operations in the year 2000 with $600 million in capital. At first, the company invested in less risky and safer investments, including merger stocks and convertible bonds. The investments would deliver moderate returns that ranged between 15% and 25% between 2001 and 2003 (Jacque, 2010). However, the company sought to redirect its investment strategies into markets that promised higher returns. In 2004, the company ventured into the natural gas industry following into the footsteps of Brian Hunter who had bet on the aftermath of Hurricane Katrina to make high returns in the natural gas markets.

Amaranth invested in futures by anticipating a steep drop in near-term prices. This assumption was based on the understanding that the 06 March futures would drop in value compared to their original prices allowing the company to close its position at a profit. However, the projections turned out differently as natural gas prices continued to rise in the months leading to September 2006. The company failed to recoup its original investment leading to the staggering $5 billion loss.

Volatility of Oil Prices

The U.S oil and natural gas sectors are closely related to one another. Pricing of the natural gas products depends to a large extent on the oil prices. It is expected that the when the oil prices rise the prices of natural gases will also rise. Fundamentally both are subject to the market push of demand and supply (Li et al., 2017). However, I do not expect the prices of natural gas to be more volatile than the oil price. On the contrary, oil prices would be more volatile than natural gases. An increase in the oil prices is likely to lead to increased drilling for oil that might push for reduced gas production resulting in higher prices for natural gas.  Although Amaranth expected the prices of natural gas to drop because of the large stockpiles of oil, their prediction did not reflect the actual market behavior.

Fluctuations in Demand for Natural Gas

The seasonal prices of natural gas fluctuate with the level of demand and supply. They are dependent on demand in the domestic consumer markets, industries and commercial businesses. While the industry and commerce demand levels remain relatively regularly throughout the year, it is the variability in the local consumer demand that fluctuates more rapidly (Jacque, 2010). The heating season during the winter leads to higher demand for natural gases while it is lowest during summer. It is against these variations that Amaranth speculated how the market prices of natural gases would behave (Li et al., 2017). The problem is that the Amaranth distorted the market prices by investing heavily in the natural gases and changing its positions so often that they were warned severally by the regulator.

Causes of Amaranth Company

Amaranth collapsed mainly because they ignored the liquidity risk that their investment presented. The speculation in the natural gases included pumping more money into the futures without due consideration of the dangers it gave to the bottom line. The initial position assumed by Amaranth was at 10% of the market derivatives in the natural gas sector (Jacque, 2010). However, by increasing the amount of investment in the riskiest portfolios spanning a calendar year, Amaranth assumed higher risk that was greater than its base assets. When the regulator demanded disclosure of its baseline, Amaranth was forced to liquidate its assets to cover the losses.

The primary reason for the collapse was the losses incurred in the speculative futures market. The speculation that the market prices would rise or fall is not predictive. Yet, this is the reality in the futures and hedge fund investments (Sundaram, 2012). When the speculations turn out correct, the firm made billions of dollars in profits. However, over-investment in 80,000 contracts when the company had already invested heavily in the 30,000 and 40,000 contracts resulted in massive losses (Jacque, 2010). Critically, the refusal by J.P Morgan to bail out Amaranth turned out to be the critical decision that led to the company’s collapse. Despite the massive losses, Amaranth was on the cusp of restoration having secured a rescue plan with Merrill Lynch and Goldman Sachs. However, the project was scampered by concerns from J.P Morgan that releasing Amaranth’s collateral would leave many futures unsecured.

Factors to Monitor in the Natural Gas Sector

Investors in the natural gas markets should monitor the periodic changes in the prices of oil. Natural gas prices tend to fluctuate according to oil prices. When oil prices rise, it is expected that prices for natural gas would also rise (Li et al., 2017). It is also essential to monitor major announcements in the industry, such as projections in the level of demand for the natural gas products. The changes in the level of demand ultimately affect the prices of natural gases.

Allied Irish Bank: A case study of Risks Inherent in Trading in Options

Case Summary

Allfirst was a subsidiary bank belonging to Allied Irish Bank (AIB). In February 2002, the subsidiary reported a massive loss of $691 million that was traced to its trading activities in the foreign exchange. The company had hired a foreign currency trader called Rusnak to undertake what he promised to be an easy way that the bank could use to grow its revenue channels and profits.  The trader began investing in currency option by arbitrating the forward market with the opportunity. However, this method proved to be loss-making. When the losses mounted, Rusnak delved deeper into the yen currency with disappointing effect. The possibilities involved Rusnak investing in the yen at strike prices that promised higher returns when the yen appreciated against the dollar.  Rusnak entered a contract to buy the dollar in the expectations that it would depreciate over time, allowing him to redeem the deal at stipulated time at a profit.

Call vs Put Options

An option is a financial instrument within the derivatives whose value is based on certain underlying market assets. There are two types of options- the call option and the put option. The call options allow the investor to purchase the asset at a given price within a defined period (Sundaram, 2012). On the other hand, put options will enable the investor to dispose of an asset that could be a stock at a stated price within specific timeframes.

Value of Deep-in-the-Money vs. Out of the Money

A deep in the money option arises if it is in the money with an amount that exceeds $10.  Put options and call options can both be called deep in the money with the call option suggesting that the strike price of the asset is less than the market value by at least $10 and $10 more for the put option (Hulshof et al., 2016). On the other hand, out of money options are those that only have intrinsic value. The deep in the money option has considerable inherent value compared with the out of money options making them excellent strategies when dealing with long term investment (Hulshof et al., 2016). The advantages of investing in opportunity are similar to those of investing in the underlying assets with the benefit of lower capital outlay lower risk, and more significant potential.

Why Rusnak Managed to Conceal Fraud

Weak control systems were responsible for the longstanding fraudulent activities at Rusnak was able to conceal his fraudulent activities by manipulating the departments and offices that were supposed to play the role of checks and balances. In essence, Rusnak’s malpractices were sustained through an elaborate system of manipulations that reduced the ability of the Back Office to check and confirm the trading activities done between Rusnak and the broker or counterparties that were dealing with the trader (Rusnak). Ordinarily, Rusnak was supposed to execute his trading activities, write the trade tickets, and keep a log of all the activities. The back office should have captured the details into the accounting and performed independent verification of the trader’s activities (Sundaram, 2012).  The details of the transactions could have been verified and validated by the Back Office before settlements were made. However, these procedures were ignored at the word of Rusnak, who then performed the confirmation bit.

Red Flags in Put and Call Options

Entering pairs of put and call option at equal prices should be alarming to the organization. The apparent existence of a put and call option at same or similar strike price with the same premium does not exist. Furthermore, while the same prices between put and call option could be excused, it was unreasonable to expect the two investments to cancel out when their expiry dates seemed to differ substantially (Sundaram, 2012).  This should have raised the red flag enough to warrant investigations. There were no confirmations given in respect of the call and put option that Rusnak had traded.

The international currency option put-call model can be used for arbitrage. The model gives the buyer the right but not the obligation to purchase a call contract or to sell an agreed amount of foreign currency at agreed prices.  The agreed prices, usually called strike prices, are typically negotiated and apply on the expiration or maturity of the contract (Hulshof, van der Maat & Mulder, 2016). The holder of the option allows for selling at a premium when the deal is conceived.

Exchange-Traded Currency

It would have been trying for Rusnak to conceal his fraudulent activities had he speculated through the exchange-traded currency. This is particularly impossible because, in this system, the bank would have been required to exchange it coins rather than performing paperwork without real movement of funds as is the case with the over-the-counter methodology that Rusnak preferred (Sundaram, 2012). Progress in the bank’s cash could have impacted the working capital of the organization quickly enough to warrant investigations.

The cost of financing deep-in-the-money options can be understood within the context of the risk that the investor carries. The possibilities are determined on the basis of the likelihood that the changing currency values will be favourable by the expiry of the contract. However, it is difficult to predict market behaviour, which presents significant risks to the investor.

References

Jacque, L. L. (2010). Global derivative debacles: From theory to malpractice.

Li, H., Zhang, H. M., Xie, Y. T. & Wang, D. (2017). Analysis of factors influencing the Henry Hub natural gas price based on factor analysis. Petroleum Science, 14(4), 822-830.

Sundaram, R. K. (2012). Derivatives in financial market development. London: International Growth Centre, 39. Retrieved from https://www.theigc.org/wp-content/uploads/2015/02/Sundaram-2012-Working-Paper.pdf

Hulshof, D., van der Maat, J. P., & Mulder, M. (2016). Market fundamentals, competition and natural-gas prices. Energy Policy, 94, 480-491.