To Loring Woodman

Pioneer of permanently affordable

housing for Jackson Hole
DERIVATIVES RISK
AND
RESPONSIBILITY
The Complete Guide to Effective
Derivatives Management and
Decision Making

Robert A. Klein

Jess Lederman
Editors

IRWIN
Professional Publishing
Chicago Bogota Boston Buenos Aires Caracas
London Madrid Mexico City Sydney Toronto
 Preface

Over the last few years, we have had the privilege of working with some of
the most talented practitioners and academics in the world to produce two
books that have become indispensable for participants in the derivatives
market: The Handbook of Derivatives and Synthetics (Probus Publishing,
Robert A. Klein and Jess Lederman. 1996
1994) and Financial Engineering with Derivatives (Irwin Professional
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
Publishing, 1995). Derivatives Risk and Responsibility, our third book on
transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or
otherwise, without the prior written permission of the publisher.
the derivatives market, is in some ways our most ambitious, and perhaps
most important effort to date.
This publication is designed to provide accurate and authoritative information in regard to the
subject matter covered. It is sold with the understanding that neither the author or the publisher is The critically important role that derivatives play in both profit maximi
engaged in rendering legal, accounting, or other professional service. If legal advice or other zation and risk reduction has recently been overshadowed by numerous
expert assistance is required, the services of a competent professional person should be sought. well-publicized financial disasters. Derivatives Risk and Responsibility is
From a Declaration of Principles jointlv adopted bv a Committee of the American Bar intended both for the senior manager or board member who is unfamiliar
Association an a Committee of Publishers. with derivatives and for the seasoned professionals who, more than ever,
Irwin Professional Book Team must assure themselves that they have all the tools and knowledge
Publisher: Wayne McGuirt
necessary to avoid the mistakes that others have made. Part One features
Associate publisher: Michael E. Desposito
seven chapters that are intended for officers with oversight responsibility,
Executive editor: Kevin Commins

but who may not necessarily have technical knowledge of the derivatives
Managing editor: Kevin Thornton

Marketing manager: Kelly Sheridan

markets. Part Two consists of seven chapters that discuss the state of the
Project editor: Rebecca Dodson
art in derivatives risk management. The five chapters of Part Three cover
Production supervisor: Lam Feinberg/Carol Klein

critical accounting, tax, systems, and control issues, while the five chap
Assistant manager. desktop services: 10n Christopher

Compositor: Weimer Graphics, Inc.

ters of Part Four deal with a wide and comprehensive range of legal and
Typeface: lJ/13 Times Roman
regulatory matters. The Appendices provide a checklist on the relative
Printer: Quebecor/Book Press, Inc.
roles of the board and senior management as well as a wealth of informa
..,. Times Mirror
tion on derivatives software products.
~ Higher Education Group

Many thanks are owed to the 37 authors, who took valuable time from
Library of Congress Cataloging-in-Publication Data
their hectic schedules to make this important book possible. We are also
Risk derivatives and responsibilities / edited by Robert A. Klein,
grateful to the superb staff at Irwin Professional Publishing.
Jess Lederman.

p. em. Jess Lederman

Includes bibliographical references and index.
Robert A. Klein
ISBN 1-55738-903-9

I. Derivative securities. I. Klein, Robert A. (Robert Arnold),

1953- . II. Lederman, Jess.

HG6024,A3R57 1966

95-38517

t
332.6--dc20

Printed in the United States of America

1234567890 QBP 21098765
 .........

24 Part I / Management

PERIPHERAL ISSUES IN DERIVATIVES RISK Chapter Three

MANAGEMENT FOR BANKS

The Bankers Trust censure by the Federal Reserve Board and the $10 Understanding the
million fine levied by the Securities and Exchange Commission (SEC) and
the Commodity Futures Trading Commission (CFTC) has highlighted Difference Between Hedging
what may become a more prominent area of risk to banks engaged in
derivatives trading. Though the problem of the misconduct of derivatives and Speculating
salespeople is not directly related to the management of derivatives risk
per se, it is directly related to a breakdown in management controls and
can pose a significant financial liability to derivatives dealers. Moreover,
Greg Beier
while Fed chairman Alan Greenspan specifically noted that the regulations
Vice President
imposed on Bankers Trust should not be construed as setting the guide Hanmi Securities
lines for all derivatives dealers, the tendency toward stricter regulation
and increased customer scrutiny-in this area should compel banks to take
a harder look at their derivatives dealings with corporations. Dealer banks
are already required to assess whether a transaction is consistent with the
counterparty's policies and procedures; real or perceived lapses in this
regard can leave a bank holding the bag in the case of a derivatives blow
up by a customer.
INTRODUCTION

Understanding the difference between hedging and speculating is a critical

skill for those responsible for derivatives risk, such as a director, a
portfolio manager, or a treasurer. Without it, these individuals run a greater
risk of losing a substantial amount of money, like those listed in Table 3-1
below, entitled "Body Count." Each firm lost money through a hedging
program. The Body Count strongly suggests that there is a significant
misunderstanding of the term "hedging."

TABLE 3-1
"Body Count"

Firm Dollar Loss * Source of Loss

Mead $12.1 million Leveraged interest-rate swaps
Gibson Greetings $16.7 million Leveraged interest-rate swaps
Dell Computer $35 million Leveraged interest-rate swaps
Olympia & York $65 million Interest-rate swaps

25
26 Part I / Management Chapter 3 / Understanding the Difference Between Hedging and Speculating 27

TABLE 3-1 (concluded) hedge funds generally engage in leveraged speculation and have nothing to
do with hedging. The original meaning is practically irrelevant.
Firm Dollar Loss * Source of Loss
The term "hedge" followed a similar pattern of distortion as the
Air Products $113 million Interest-rate and currency swaps derivatives markets developed. Initially, hedging meant balancing gains
Procter & Gamble $157 million Leveraged currency swaps and losses. With the introduction of viable options exchanges, the com
Codelco $207 million Metal derivatives
plexity of hedging jumped, since options provided so many new ways of
Granite Fund Mgmt. $600 million Mortgage derivatives
addressing specific risks that the definition of hedging was significantly
Metallgesellschaft $1.34 billion Oil futures
stretched. Eventually, a whole menagerie of other derivatives were devel
Kashima Oil $1.53 billion Currency forwards
Showa Shell Sekiyu $1.66 billion Currency forwards
oped. Hedging began to cover any kind of risk that was changed through
using a derivative; very often this is not necessarily risk reduction.
Total $5.736 billion

*These figures have been taken from media sources. Actual final losses may vary.
DERIVATIVES GROWTH

At first blush, it would seem that understanding the difference between
hedging and speculating is quite simple. Speculation is a plain old simple
bet; the assumption of risk. Hedging, on the other hand, is taking action to
reduce risk. In the real world, though, things are more complicated than this,
as the Body Count can attest. Hedging with derivatives does not implicitly
mean risk reduction. The intention may be risk reduction but in reality what
happens is that the bet is shifted from the performance of the asset to the
performance of the hedge (the underlying asset and the derivative hedge
instrument together). When a hedge is entered, one is speculating on the
risks of hedging, not on the direction of a price or a volatility.
At this point, it may be useful to look at how and why the derivatives
markets developed. Exploring the primary trends that established deriva
tives provides a framework for approaching current issues. The forces
behind the growth of the derivatives marketplace also supported the
change in the meaning of the word "hedge." Since the equity bear market
of 1974, the rise of derivatives use has been chiefly driven by the end of
fixed commissions, the information technology (IT) effect, and a favorable
derivatives growth environment. The end of fixed commissions allowed
bets to be changed at a low cost. The IT effect made it possible to easily
identify previously unseen risks. The favorable growth environment en
couraged the use of derivatives to change bets to fit specific needs.

DISTORTED TERMS
The term "hedge" by itself does not have meaning today. The term has
become distorted to serve the needs of promoters. Salespeople have learned
that it is easier to sell a hedge product than a speculative one, since the
customer is always looking for a "sure thing," a chance to get a big gain
with little risk. The evolution of the term "hedge fund" is a good example.
When hedge funds first appeared about 30 years ago, they originally
pursued a strategy of being long and short stocks. Hence, the logic went,
these funds were hedged. Before long, hedge funds were taking long and
short positions in practically anything. New funds that were brought to
market that were using the same investment policy were also called hedge
funds. The term became more commonplc:lce and desirable to use. Now,
Fixed Commissions
The end of fixed commissions in 1975 prompted brokerages to do princi
pal (over-the-counter, or OTC) transactions, develop new products, and
increase agency (client) volume as revenues slid from declining commis
sion rates. Derivatives fit the new needs of Wall Street in every respect.
In the past, good client relationships were the franchises that brought
business into most investment banks. As competition increased-much of
it precipitated by the end of fixed commissions-new products like
derivatives became crucial to the growth of many Wall Street firms, since
they offered a means to establish a franchise. Firms have been willing to
take the investment risk of creating derivatives franchises because good
new products always command a high premium. As always, competition
drove down fees, but brokerage firms had a chance to retain market share
 JIIII"'"
28 Part I / Management
by adding different spins to the same product concept and by creating an
air of authority from being the originator that attracted business. The sheer
differe~~e in the number and kinds of financial products available between
1975 and today is simple proof of this trend.
New kinds of derivatives usually require the originating firm to make a
market in the product. Brokerage firms have been willing to take the risk
of making markets since it can be a lucrative business. The often large and
undisclosed fee to clients has made principal trading a core business
activity of most large firms. The growth of the NASDAQ market, which
rose from its humble origins to challenge the New York Stock Exchange,
is a reflection of this trend. A widely recognized symbol of this change has
been the growth of the market capitalization of Microsoft relative to the
decline of IBM.
New derivative products often required other transactions to be done as
part of a broader strategy, thereby satisfying the need of firms to increase
client volume. For example, dynamic hedging requires one to regularly re
balance the hedge instruments through buying and selling. Though a valid
idea, dynamic hedging is also a commission generator. Volume also gets
driven up by clients, who can now take much larger positions and hedge
specific risks. Additionally, block trading greatly increased the rate of
growth in equities volume after 1975.
The Information Technology Effect
The Information Technology (IT) effect is the impact of declining costs
amid the rising power and reliability of information technology (hardware,
software, and telecommunications) on finance. The IT effect has benefited
brokerages by creating price models, speeding up new product develop
ment, and increasing transaction volume.
The IT effect made real-time price models a reality. Cheap computing
power allowed investors to quickly process large amounts of information,
which was previously not possible. For example, the idea of duration (a
common measure of a bond's volatility) has been around since 1938 but
did not gain widespread acceptance until the 1980s, when the platforms
were so broadly available that everyone could calculate it. The faith of the
derivatives marketplace rests on these models. The IT effect also made
OTe markets fast enough to compete with the organized exchanges.
The IT effect has led to increased liquidity for the derivative markets.
Since the inputs that make up the prices of a derivatives market are widely
Chapter 3 / Understanding the Difference Between Hedging and Speculating 29
available, market participants can calculate values for themselves to check
the dealer or exchange quotes. As mentioned, this increases the investors'
confidence and the transparency of prices. The IT effect also ~nhances
liquidity by pooling a global base of investors through worldwide real-time
quote systems. By tying together markets from around the world and across
asset classes, the IT effect has created demand for new products too.
New product development has also been driven by the IT effect. Deriva
tives developers create pictures of previously unseen risk through crunching
vast amounts of data. Developers then securitize the solution into a deriva
tive product or strategy to sell. This process of isolation, analysis, and
securitization has been at the heart of the derivative product cycle.
Favorable Development Climate
The conditions for derivatives product development have been very favor
able. After the 1974 bear market, fixed commissions died, the options
exchanges started to grow, and the inflation scare of the late 1970s and
early 1980s motivated the financial community to devise a means to hedge
risk. Additionally, investors have been confident to tryout new products
because the bond and equity markets have performed well since 1982. The
huge interest-rate decline in 1993 pushed many bond fund managers to the
edge of risk to capture extra yield, which drove demand for fixed-income
derivative products to the extreme. Moreover, the regulatory environment
loosened considerably under Republican administrations, allowing finan
cial innovation to flourish.
THREE KINDS OF HEDGING
The following sections will explore three new ways of breaking down
hedging activities, as well as the different risks of each. The main point to
bear in mind is that a hedge is merely a shift in the kinds of bets one is
making.
The Straight Hedge
A straight hedge is the most common form of hedging. Normally, some
one has an asset, called the underlying in derivatives parlance, and
develops the opinion that the price of it will go down. Through using a
 ~
30 Part I / Management
FIGURE 3-1
Symmetric cash flows
Positive
short hedge
combined
Price
position
long asset
Negative Time Positive
derivative of the underlying asset, such as a bond future for a bond, one
can sell short to hedge the value of the underlying. The goal, therefore, is
to freeze the value of the asset. Any price rise or decline of the underlying
asset is offset by the derivative hedge. In fancier terms, a straight hedge is
an attempt to make the cash flows between the asset and the hedge
instrument symmetric so that the losses and gains cancel each other out.
Normally, the hedge instrument is a derivative substitute or other close
proxy to the asset being hedged, so a change in the value of one is closely
balanced by the other, and the price of the asset remains stable at around
where the hedge was initiated.
Examples of strait hedges are numerous and easy to see. A farmer, who
has a field full of wheat, sells wheat futures to lock in the price of his crop
prior to harvest. A portfolio manager, who owns a lot of bonds, sells bond
futures to freeze the value of her portfolio. A company, expecting to buy
$100 million worth of yen, enters into currency forwards to lock in a
dollar-yen exchange rate.
In Figure 3-1, the prices of a short hedge, a long asset, and the
combined positions of the long asset and short hedge have been plotted
over time.
The risks of straight hedging are as follows:
Correlation risk is the most common risk in all hedging. Correlation
risk is the risk that the value of the hedge instrument will change unequally
Chapter 3 / Understanding the Difference Between Hedging and Speculating 31
to the value of the asset as the asset changes value in the marketplace.
Correlation risk always increases when the hedge instrument is not a direct
derivative of the underlying, such as a Treasury bond future being used to
hedge corporate bonds.
Ratio risk is the risk of using the correct amount and combination of
hedge instruments. Ratio risk always increases when the hedge ratio
changes with price changes.
Execution risk is the risk that a hedge may be improperly initiated or
liquidated. Execution risk is always higher when strategies like dynamic
hedging require hedge positions to be changed regularly.
Liquidity risk is the risk that the hedge instrument cannot be purchased
or liquidated at the correct price. It is pointless to enter a hedge if one
cannot get out of it. The simplest test of liquidity involves a knowledge of
the number of firms that make a market in the hedge instrument, the daily
volume, and the conditions that will change the volume. The riskiest
hedge instrument to use is illiquid and leveraged.
Model risk is the risk that the derivatives pricing model may be
incorrect. Particular attention must be paid to see if the assumptions that
are being used to determine the structure of a hedge are sound; models are
only as good as their assumptions. There is no one standard model and
there are many different ways of estimating prices. Other model risk issues
are frequency of pricing, margins for error, and even the data used if the
instrument is not priced on an exchange market (since there are many
different market-makers in an aTe market). Many models use short data
sets that work well with small fluctuations but often produce incorrect
analysis when large trends change. Subsequently, hedges are least likely to
work as expected when the markets are at extremes in price, volatility, or a
trend's length.
Options hedge
An options hedge is like buying insurance. The goal is to pay a price for
protection from specific events. It is an attempt to keep a value above,
below, within a range, or outside of a price range for a finite period of time.
The goal is to purchase the possibility of exposure without having to
assume it unless it is needed, which is like insurance. Again, to use fancier
terms, the result is an asymmetric cash flow. This means that the value of
the underlying asset remains unchanged by the option (less the cost of the
option) unless the option is elected (see Figure 3-2).
32 Part I / Management
FIGURE 3-2
Asymmetric cash flows
Positive combined position
Put's strike price
is elected.
Price
I long put .,
: long asset
Negative Time Positive
Examples of options hedges are a bit vaguer. A money manager,
worried about a decline in the stock market, purchases a portfolio put (a
put specifically tailored to protect his portfolio). If the stock market goes
up or stays sideways until his put expires, then he has lost the money he
paid for his put. If, though, the stock market sinks below the strike of his
put, then the put will help to protect him by increasing in value as the
market goes down.
Option risk is a complex combination of the aforementioned risks. In
fact, options can behave in ways that even the best traders do not
understand at times. Questions arise such as: Will the option be properly
valued in the marketplace? Will its valuation respond to changes in the
underlying market? How often will the hedge ratio have to be changed?
Options also add additional risks such as interest-rate risk and volatility
risk. Liquidity risk is always another important consideration with options
hedging. There is an old comparison of illiquid options to roach motels,
"You can get in but you cannot get out," that is helpful to bear in mind
when considering whether to enter a potentially illiquid option position.
Speculative hedge
A speculative hedge is an attempt to protect the value of an asset by using
a proxy when the hedge instrument is not a derivative of the asset or when
Chapter 3/ Understanding the Difference Between Hedging and Speculating 33
FIGURE 3-3
Nonsymmetric Cash Flows
Impossible to Plot
Since any mix of assets and hedges could be
Value used, it is impossible to plot the corresponding
value changes. This is exactly what makes
speculative hedging risky.
Time
the historical relationship between the hedge instrument and the underly
ing has been volatile beyond what one considers stable enough for a
hedge. This is where judgment risk increases (see Figure 3-3).
JUDGMENT RISK
Judgment risk is the core risk of speculative hedging. It is also the most
important risk in any kind of market operation. Judgment is the ability to
make good decisions. Poor judgment causes most financial disasters by
letting one of the aforementioned risks get out of control.
Generally speaking, experienced professionals just do not wake up one
morning and decide to put on a trade that could end up losing a billion plus
dollars. They lure themselves into it. The loss of judgment occurs slowly,
normally with the acceptance of market trends as facts. Therefore, the
biggest losses normally follow the biggest successes. A big win gives
people the courage to make huge bets. Big bets are easy to make (and hide)
with derivatives. Big bets cause disasters. Any of the risks so far described
apply here and can. cause a disaster if a big bet is made.
As trends progress in markets, judgment decreases. The proof of this is
in financial history. Over the years, there have been many examples of
34
Part 1/ Management
FIGURE 3-4
Inverse Market-Judgment Relationship
Judgment
2 3
Price 1
Market rally
Time
competent professionals making tremendous bets near the extreme tops
and bottoms of markets, resulting in large losses. A large loss almost never
happens without a trend being in effect.
The effect of trends on judgment can be graphed with two lines (see
Figure 3-4). The first represents the time and size of the move and the
second is a generalization of a person's judgment quality going down as
the market rallies. At point one, the trend has just started and everyone's
judgment is as its sharpest. At point two, everyone relaxes, relieved that
things are working out as expected. They may even increase their bets
here. At point three, everyone is ecstatic and caution is thrown to the wind.
Judgment almost ceases to exist.
EXAMPLES OF DERIVATIVES DISASTERS
Metallgesellschaft AG
MG Corp., the U.S. subsidiary of the German concern Metallgesellschaft,
lost roughly $1.34 billion in oil futures. MG quickly grew an oil supply
business through offering 5- to lO-year petroleum supply delivery deals.
These contracts are the same as making short sales. They hedged their
short exposure by going long oil futures. As the business continued to
Chapter 3 / Understanding the Difference Between Hedging and Speculating 35
increase, so did their oil positions, until eventually they held more than 20
percent of the long positions in the first three months of crude-oil futures.
Their strategy was dependent on the front months of crude-oil trading at
a premium to the back months. If MG could sell the front months at a 10
cent premium to the back months, then rolling over their oil-futures hedge
would work. MG made an enormous bet that the front months would stay
at a premium for the life of the oil delivery contracts. The only problem is
that oil back-months can trade at a premium to the front months and
sometimes do. This is exactly what happened.
In November 1993, the November gasoline futures were trading 3.15
cents over the spot (cash market) month. MG had 40,000 gasoline futures
contracts to roll over, which at that premium required $53 million. To put
this figure into perspective, the U.S. subsidiary needed more than two
times the parent company's 1992 net profits of $26.7 million to cover a
hedge that was failing to work. As the losses began to mount, the parent
company reported that they did not know what was happening at their U.S.
unit. They said they were misled.
This is a good example of how a hedge can be deceptively complicated.
If MG had been hedging oil-supply deals of the same length as the their oil
futures, then they would have been engaging in a straight hedge. But
because they entered into long-dated short sales and could only hedge with
a short-term instrument, MG entered into a speculative hedge. They were
speculating on the correlation risk between the underlying and the cash
market. MG made a bet on the price relationship between the front months
and back months of energy futures to offset the risk of their long-term
obligations. This is a good example of a speculative hedge, since it is well
known that the relationship between the front and back months can change
with supply/demand shifts.
The Carry Trade
Many banks got involved in the carry trade as the economy went into a
recession. Their rationale was that loan demand would decline as business
activity slowed, and this would produce lower interest rates. Therefore, in
order to hedge their earnings against weak loan demand, aggressive banks
entered into swaps, where they received a fixed long-term rate and paid a
short-term rate. If, for example, the 5-year rate was 8 percent and the
I-year rate was 4 percent, the bank gained a positive carry of 4 percent, a
hefty gain without having to take any credit risk if the bonds are
36 Part 1/ Management
u.s. governments. Ironically, several of the entities that were hurt the
worst by the carry trades were nonbanks, such as Orange County and
Procter & Gamble. These organizations were engaged in leveraged carry
trades that backfired when rates rose in 1994.
Granite Partners
Granite Partners was a New York hedge fund that lost $600 million in
mortgage derivatives. Granite is a good example of distorting the term
"hedge" for marketing needs and of problems with models. Granite sold
itself to prospective clients by claiming in its sales literature "to use a
great deal of leverage when trading CMO derivatives." They went on to
claim that a client's risk is "very little when investing through Granite,
[since] when market conditions are not favorable, Granite has the option to
wait it out until conditions improve." These marketing statements were a
warning to investors, since leverage means that price moves magnify
losses and gains. A leveraged portfolio always has less staying power than
an unleveraged portfolio. Eventually, the bond market went against their
positions and they started losing money. Granite believed that the dealer
quotes were incorrect, so they began marking their positions to their in
house models, which offered more favorable prices than the brokerage
firms. In the end, Granite had to report large losses to their clients and the
firm was shut.
THE THREE FAILURES
Derivatives are likely to continue to cause more problems, since the
knowledge, accountability, and judgment failures that caused the previous
disasters still persist, according to surveys of derivatives users. Until these
failures are corrected, terrible losses will continue. Eventually, some
mega-event (e.g., a nuclear strike, an assassination, a major default, war)
will quickly move the markets far outside their normal ranges and likely
bankrupt the derivatives users that are unprepared. Given the amount of
leverage in many derivatives, a "blow-out" scenario from massive market
moves against expectations is a real probability for the future. The only
question is when? In one year? Five years? Ten years?
This bold forecast is not without precedent. Before 1929, stocks were
widely considered to be extremely speculative while bonds were for the
Chapter 3 / Understanding the Difference Between Hedging and Speculating 37
prudent investor. The Great Crash and events since have taught the
financial community how to manage a stock market, and equities are now
core holdings of pension funds and trusts. Like stocks were then, deriva
tives are still in their youth and are likely to cause trouble until the
regulations and training are implemented so that the marketplace can
understand and manage these products. The first step in avoiding a
derivatives disaster is to ensure that the three kinds of failures that cause
large losses are being dealt with.
The first failure that can cause a derivatives disaster is a knowledge
failure. It is the easiest to correct. In order for an organization to use
derivatives, the people involved in the decision-making process should
know what they are doing. Given the technical nature of derivatives and
the desire by busy executives to delegate, the top management of many
organizations do not understand the risks that they are taking. This can be
easily remedied by training, reading, and gradual experience. According
to a survey conducted by Record Treasury Management in England,
nearly three-quarters of all treasurers in the Financial Times 100 compan
ies marked their positions to market on a monthly basis. Since it is widely
accepted that derivatives positions should be marked-to-market on a daily
basis (or at a minimum on a weekly basis), it is apparent that knowledge
failure is still widespread.
An accountability failure is the second failure. Accountability failure
means that the controls are not in place to have derivatives used in an
organization. The two primary controls needed are a policy statement and
an evaluation procedure. A policy statement defines what derivatives are
supposed to do, what kinds of risks can be managed if there is hedging,
how much a firm is willing to lose if things go \vrong, how derivatives are
valued, and what kinds of instruments can be used. The evaluation
procedure is the way that the policy statement is enforced and updated. It
is also the way the organization learns what strategies are best for them to
use and what are not. The evaluation procedure specifically defines who is
responsible for what and how tasks are supposed to get done. Markets
move in real time, and an organization must be prepared to do so as well.
The third failure is the most devastating. It is a judgment failure. The
biggest derivatives risk in an organization is not in the markets, as is
commonly thought, but in the individuals making the decisions and imple
menting them. A large bet made outside the mandate of the policy statement
and unchecked by the evaluation procedure can bring an organization down.
Companies listed on the Body Count (Table 3-1) learned this.
 ---
Part I / Management
38
CONCLUSION
Some day, markets will move violently. It is a fact of life. Those who are
ill-prepared and are holding risky positions could get wiped out. It is in the
interest of everyone who uses derivatives to understand the kinds of bets
that they are making and to determine if these bets are appropriate for what
they are supposed to be doing. Large losses, especially if they are outside
the mandate of the risks to be hedged, could permanently destroy the
careers of those who have responsibility for derivatives risk.
Chapter 3/ Understanding the Difference Between Hedging and Speculating 39
Appendix 3A
Signs of Judgment Failure
INTRODUCTION
The following discussion of judgment failure can be applied to any kind of
business where success or failure depends primarily on decision-making
skills. For derivatives, judgment (the ability to make good decisions) is
paramount.
Grasping the risk picture of any business is always a challenging task.
The job becomes even more difficult when reviewing risks that derivatives
present. It is probably impossible for many with responsibility for deriva
tives risk to be able to determine for themselves what their actual risk level
is from derivatives. Most executives do not have the time to study the
derivatives positions until it is too late.
The biggest derivatives risk an executive has does not come from the
markets but from the people working with derivatives. Therefore, the
simplest solution to this problem is for an executive not to put his or her
energy into gaining a deep understanding of derivatives but to leverage the
existing base of people-skills by carefully observing those handling deriv
atives on a daily basis. People are the "markets" an executive must
scrutinize for risk. The key is to determine when people are likely to be
involved or get involved in exorbitant risk and then intervene. There are
many signs of judgment failure, but they can be distilled down to two
classes: overconfidence and hypertension.
Overconfidence
Overconfidence in one's abilities can lead to making big bets, which are
the cause of all disasters. Overconfidence is most apparent in the way
people spend money both on themselves and on their business overhead.
The signs of an employee's personal spending getting out of control
are:
New custom-made clothes, especially if the person did not wear
them before-this is almost always a dead giveaway.
Expensive sports cars, especially Porsches.
 Chapter 3 / Understanding the Difference Between Hedging and Speculating 41
40 Part I / Management

Always going to expensive restaurants. so previously. Another way would be for him to "discover" some new
way of doing things that is a "sure thing." These "discoveries" tend to
Costly jewelry, watches, and cuff links.
lead to problems, since his judgment is already skewed.
A big house. The second change is that an employee cannot admit he is wrong. He
Excessive dating. can see only what he wants to see. The danger is that he will not take a loss
when a position starts losing a lot of money or a trade does not work out as
A large expansion in business overhead expenses is the other reliable sign
expected. This behavior is at the heart of every single derivatives disaster.
of overconfidence taking root. Overhead normally balloons in two ways.
If a manager sees this problem in any shape, he must act.
The first is a hiring binge. An investment bank, for example, went from
one derivatives specialist to 70 in a single year before the derivatives
business went into a severe decline the next year. The other way deriva Fraud
tives professionals raise fixed expenses is through substantially increasing
There is one other important advantage of looking for judgment failures.
the amount of quote terminals and sophisticated computers. If a depart
Many executives claimed that they were lied to by their own employees
ment suddenly has several times the amount of equipment that they
about the size of the losses. Since a manager is relying on herself to check
previously had and their needs have not changed much, a problem may be
the judgment quality of her derivatives staff, she is more likely to detect a
brewing.
situation that creates strange changes in their behavior. If the profit-and
loss statement does not show a change but the situation still seems amiss,
Hypertension then a manager can order an audit of the positions by an outside consult
ant, thus protecting herself from fraud.
Hypertension, or extreme stress, causes people to not think through
situations in a clear and rational manner. They are also more likely to
make simple mistakes and disrupt teamwork. The signs of hypertension in Good Judgment
an employee include Good judgment comes from a commitment to deal with reality-to see
Extreme irritability. things as they are. An employee who shows good judgment will avoid
prolonged periods of extreme optimism or pessimism. He will stick with
A need to watch every quote, since he or she is afraid of missing
getting all of the facts and then make a decision based on those facts. Risk
something.
of judgment failure declines if these qualities are evident.
Long-standing business and personal relationships end.
Divorce.
Always working and unable to take a vacation, even if asked to. CONCLUSION
Gaining or losing a lot of weight.
If a careful eye looks out for overconfidence and hypertension to develop,
especially when there is a big price trend in the markets, then the
Combined Result probability of catching a problem before it happens increases.
Taken together, overconfidence and hypertension tend to create two
changes in an employee. The first is that he is likely to stop doing what
made him successful in the first place. There are many ways this can
happen, but the most common is for an employee to start spending a lot of
time in the evenings going out to restaurants and clubs when he did not do